Anthony E. Henry · Understanding Strategic Management
Third Edition
UNDERSTANDING
STRATEGIC
MANAGEMENT
Third Edition
Anthony E. Henry
3
3
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© Anthony E. Henry 2018
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First edition 2007
Second edition 2011
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‘and you shall know the truth, and the truth shall set you free.’
John 8:32
Brief Contents
Contents in Full
ix
List of Cases
xv
Acknowledgements
xvii
About the Author
xviii
About the Book
xix
How to Use this Book
xx
How to Use the Online Resources
xxii
PART ONE WHAT IS STRATEGY?
1 What is Strategy?
3
PART TWO STRATEGIC ANALYSIS
2 Evaluating the Macro-environment
35
3 Industry Analysis
57
4 The Internal Environment: Value-creating Activities
85
5 The Internal Environment: A Resource-based View of Strategy
114
PART THREE STRATEGY FORMULATION
6 Business Strategy
143
7 Corporate Strategy
174
8 International Strategy
205
PART FOUR STRATEGY IMPLEMENTATION
9 Organizational Structures and Strategic Change
239
10 Strategic Leadership
271
11 Corporate Governance
301
Glossary····························································································································································································331
Name Index·····················································································································································································339
Subject Index··················································································································································································344
Contents in Full
List of Cases
xv
Acknowledgements
xvii
About the Author
xviii
About the Book
How to Use this Book
How to Use the Online Resources
xix
xx
xxii
PART ONE WHAT IS STRATEGY?
1 What is Strategy?
Introduction
3
4
1.1 What is Strategy?
1.1.1 Defining Strategy
4
6
1.2 Strategic Management
1.2.1 Strategy Analysis
1.2.2 Strategy Formulation
1.2.3 Strategy Implementation
8
9
9
10
1.3 Vision, Values, and Mission
1.3.1 The Theory of the Business
1.3.2 Business Models
10
14
15
1.4 Types of Strategy
1.4.1 Corporate Strategy
1.4.2 Business Strategy
1.4.3 Functional/Operational Strategy
16
16
16
16
1.5 Changes in the Approach to Strategic Management
16
1.6 Different Perspectives on Strategy Formulation
1.6.1 The Rationalist School
1.6.2 The Learning School
18
18
19
1.7 A Strategic Management Framework
23
PART TWO STRATEGIC ANALYSIS
2 Evaluating the Macro-environment
Introduction
35
36
2.1 The Macro-environment
36
2.2 Scanning, Monitoring, and Forecasting Changes in the Environment
2.2.1 Scanning the Environment
2.2.2 Monitoring the Environment
2.2.3 Forecasting Changes in the Environment
37
38
40
40
x
Contents in Full
2.3 Scenario Planning
2.3.1 How to Build Scenarios
40
42
2.4 PEST Analysis
2.4.1 Political Factors
2.4.2 Economic Factors
2.4.3 Social Factors
2.4.4 Technological Factors
2.4.5 Limitations of PEST Analysis
44
44
45
47
47
50
2.5 An Introduction to SWOT Analysis
50
2.6 The Macro-environment and Industry Analysis
51
3 Industry Analysis
Introduction
57
58
3.1 The Background to Porter’s Five Forces Framework
58
3.2 Porter’s Five Forces Framework
3.2.1 The Threat of New Entrants
3.2.2 The Bargaining Power of Buyers
3.2.3 The Bargaining Power of Suppliers
3.2.4 The Threat of Substitute Products and Services
3.2.5 The Intensity of Rivalry among Competitors in an Industry
3.2.6 Competing Using the Five Forces Framework
58
60
62
63
64
64
65
3.3 Limitations of Porter’s Five Forces
65
3.4 The Value Net
3.4.1 A Complementary Sixth Force
66
69
3.5 The Industry Life Cycle
3.5.1 Introduction Stage
3.5.2 Growth Stage
3.5.3 Maturity Stage
3.5.4 Decline Stage
70
70
71
71
71
3.6 Strategic Groups
3.6.1 Strategic Maps
3.6.2 Mobility Barriers
71
72
72
3.7 Hypercompetition and Disruptive Innovation
3.7.1 Hypercompetition
3.7.2 Disruptive Innovation
74
74
76
4 The Internal Environment: Value-creating Activities
Introduction
85
86
4.1 Background to Differential Firm Performance
86
4.2 Value chain Analysis
4.2.1 Primary Activities
4.2.2 Support Activities
87
87
89
4.3 Evaluating the Value Chain
4.3.1 The Importance of Linkages within the Value Chain
4.3.2 Managing Linkages within the Value Chain System
89
90
92
Contents in Full
4.4 SWOT Analysis
4.4.1 Integrating the Macro and Competitive Environments
4.4.2 Limitations of SWOT Analysis
93
93
95
4.5 Organizational Performance
4.5.1 What is Performance?
4.5.2 Maximizing Shareholder Value
4.5.3 Meeting the Needs of Stakeholders
4.5.4 Financial Analysis
96
96
97
98
101
4.6 The Balanced Scorecard
104
4.7 Benchmarking
106
5 The Internal Environment: A Resource-Based View of Strategy
Introduction
114
115
5.1 The Resource-Based View of Strategy
5.1.1 Resources
5.1.2 Organizational Capabilities
115
116
117
5.2 The VRIO Framework and Sustainable Competitive Advantage
5.2.1 Valuable Capabilities
5.2.2 Rarity
5.2.3 Imitability
5.2.4 Organization
5.2.5 Make-or-Buy Decision
122
122
123
124
126
128
5.3 Criticisms of the Resource-Based View
128
5.4 A Knowledge-Based View of the Firm
129
5.5 Dynamic Capabilities
130
PART THREE STRATEGY FORMULATION
6 Business Strategy
Introduction
143
144
6.1 What is Business Strategy?
144
6.2 Generic Competitive Strategies
6.2.1 Overall Cost-Leadership Strategies
6.2.2 Differentiation Strategies
6.2.3 Focus Strategies
6.2.4 Stuck in the Middle
145
147
150
151
154
6.3 A Resource-Based Approach to Strategy Formulation
6.3.1 Appraising Capabilities
6.3.2 Implications for Strategy Formulation
155
156
157
6.4 Blue Ocean Strategy
6.4.1 The Strategy Canvas
159
162
6.5 Strategy Formulation in Turbulent Markets
163
6.6 Disruptive Innovation and Strategy Formulation
6.6.1 Responses to Disruptive Innovation
6.6.2 Limitations of Disruptive Innovation
165
166
167
xi
xii
Contents in Full
7 Corporate Strategy
174
Introduction
175
7.1 Corporate Strategy
175
7.2 Growth Strategies
7.2.1 Market Penetration
7.2.2 Product Development
7.2.3 Market Development
7.2.4 Diversification
176
177
177
177
177
7.3 Related Diversification
7.3.1 Vertical Integration
7.3.2 Horizontal Integration
7.3.3 Transaction-Cost Analysis
178
178
179
179
7.4 Unrelated or Conglomerate Diversification
7.4.1 Can Conglomerate Diversification Succeed?
179
180
7.5 Implementing Growth Strategies
7.5.1 Mergers and Acquisitions
7.5.2 Internal Development
7.5.3 Joint Ventures and Strategic Alliances
182
182
184
187
7.6 Portfolio Analysis
7.6.1 Boston Consulting Group Matrix
7.6.2 The General Electric–McKinsey Matrix
188
188
190
7.7 Corporate Parenting
7.7.1 Parenting Opportunities
7.7.2 Portfolio Decisions
192
194
195
7.8 Strategic Evaluation
7.8.1 Suitability
7.8.2 Feasibility
7.8.3 Acceptability
198
198
198
198
8 International Strategy
205
Introduction
206
8.1 Globalization or Localization
206
8.2 International Strategy
8.2.1 Organizational Factors
8.2.2 Environmental Factors
208
208
209
8.3 A Globalization Framework
8.3.1 The Strategic Objectives of a Multinational Corporation
8.3.2 The Sources of Competitive Advantage
210
210
211
8.4 Types of International Strategy
8.4.1 Multidomestic Strategy
8.4.2 Global Strategy
8.4.3 International Strategy
8.4.4 Transnational Strategy
212
213
213
214
214
8.5 Entry mode Strategies
8.5.1 Exporting
8.5.2 Licensing
217
218
218
Contents in Full
8.5.3 International Franchising
8.5.4 Joint Ventures and Strategic Alliances
8.5.5 Wholly Owned Subsidiaries
219
219
221
8.6 Porter’s Diamond of National Advantage
8.6.1 The Diamond of National Advantage
8.6.2 Criticisms of Porter’s Diamond
222
223
225
8.7 The Myths of Global Strategy
226
8.8 The Challenge of Globalization
227
PART FOUR STRATEGY IMPLEMENTATION
9 Organizational Structures and Strategic Change
Introduction
239
240
9.1 Organizational Structures
9.1.1 The Entrepreneurial Structure
9.1.2 The Functional Structure
9.1.3 The Divisional Structure
9.1.4 The Matrix Structure
9.1.5 The Network Structure
240
242
242
243
244
245
9.2 Organizational Processes
247
9.3 Strategic Control Systems
249
9.4 Strategic Change
9.4.1 Integrative Change
9.4.2 Strategic Drift
9.4.3 Visionary Organizations
252
257
258
260
10 Strategic Leadership
Introduction
271
272
10.1 Leadership and Management
272
10.2 The Learning Organization
10.2.1 Building the Learning Organization
10.2.2 Leadership Roles
10.2.3 Leadership Skills
277
278
278
279
10.3 Emotional Intelligence and Leadership Performance
280
10.4 Narcissistic Leaders and Leadership Capabilities
10.4.1 Leadership Capabilities
282
283
10.5 The Impact of Leadership on Values and Culture
10.5.1 Leadership and Values
10.5.2 Leadership and Culture
285
285
286
10.6 Leading Strategic Change
10.6.1 Transformational Leadership
10.6.2 Theory E and Theory O Leaders
10.6.3 Leadership and Chaos
288
289
292
293
xiii
xiv
Contents in Full
11 Corporate Governance
301
Introduction
302
11.1 What is Corporate Governance?
302
11.2 The Origins of Corporate Governance
304
11.3 The Growth of Modern Corporations
11.3.1 Limited Liability
11.3.2 Transferability
11.3.3 Legal Personality
11.3.4 Centralized Management
305
305
305
305
306
11.4 The Purpose of Corporations
11.4.1 The Purpose of Corporations: Maximize Shareholder Value
11.4.2 The Agency Problem
11.4.3 The Purpose of Corporations: Meet the Needs of Stakeholders
306
307
309
310
11.5 Corporate Governance Codes
11.5.1 The Cadbury Committee
11.5.2 The Hampel Committee
11.5.3 Other Corporate Governance Codes
11.5.4 The Role of Non-Executive Directors
11.5.5 The Sarbanes–Oxley Act
313
314
315
316
318
319
11.6 Excessive Executive Pay
11.7 Is Reform to Corporate Governance the Answer?
11.7.1 The Pursuit of Greed
319
321
322
Glossary····························································································································································································331
Name Index·····················································································································································································339
Subject Index··················································································································································································344
List of Cases
PART ONE WHAT IS STRATEGY?
1 What is Strategy?
3
STRATEGY IN FOCUS 1.1 Organizational Values at Johnson & Johnson: How their Credo Guides Strategy
12
STRATEGY IN FOCUS 1.2 Honda’s Dominance of the US Motorcycle Industry: Deliberate or Emergent Strategies?
21
CASE EXAMPLE Intel’s Theory of the Business
25
PART TWO STRATEGIC ANALYSIS
2 Evaluating the Macro-Environment
35
STRATEGY IN FOCUS 2.1 Delays with Building Construction
46
STRATEGY IN FOCUS 2.2 Are Electric Cars the Future?
48
CASE EXAMPLE Disruptive Innovation from Netflix
52
3 Industry Analysis
57
STRATEGY IN FOCUS 3.1 Stansted Airport’s Unhappy Complementor
67
STRATEGY IN FOCUS 3.2 Apple’s Hypercompetitive Market
75
CASE EXAMPLE Ryanair: How to Compete in the Airline Industry
78
4 The Internal Environment: Value-Creating Activities
85
STRATEGY IN FOCUS 4.1 Outsourcing at British Airways
91
STRATEGY IN FOCUS 4.2 IKEA and Stakeholders
100
CASE EXAMPLE The Pursuit of Shareholder Value
108
5 The Internal Environment: A Resource-based View of Strategy
114
STRATEGY IN FOCUS 5.1 Honda’s Search for Innovation
121
STRATEGY IN FOCUS 5.2 Sir James Dyson: a Difficult Man to Imitate
124
CASE EXAMPLE The Dynamic Capabilities of Warren Buffett
134
PART THREE STRATEGY FORMULATION
6 Business Strategy
143
STRATEGY IN FOCUS 6.1 Differentiated Product Jaguar F-Pace SUV
153
STRATEGY IN FOCUS 6.2 Amazon’s Blue Ocean Strategy
161
CASE EXAMPLE Disrupting the Competition for One Dollar
168
7 Corporate Strategy
174
STRATEGY IN FOCUS 7.1 Conglomerate Diversification
181
STRATEGY IN FOCUS 7.2 Aldi and Lidl’s Organic Growth
185
STRATEGY IN FOCUS 7.3 A Change of Corporate Parent
193
CASE EXAMPLE Throw Out the Knitting and Stick to Vertical Integration
200
xvi
List of Cases
8 International Strategy
205
STRATEGY IN FOCUS 8.1 Joint Venture between Pharmaceutical and Technology
220
STRATEGY IN FOCUS 8.2 Globalization in Retreat
228
CASE EXAMPLE Inditex’s International Reach
231
PART FOUR STRATEGY IMPLEMENTATION
9 Organizational Structures and Strategic Change
239
STRATEGY IN FOCUS 9.1 IKEA’s Challenge over Strategy and Structure
246
STRATEGY IN FOCUS 9.2 Has Apple’s Revolution Come to an End?
256
CASE EXAMPLE W. L. Gore’s Unconventional Success
265
10 Strategic Leadership
271
STRATEGY IN FOCUS 10.1 UK Chief Executives
276
STRATEGY IN FOCUS 10.2 New Leadership at Microsoft
284
CASE EXAMPLE Transformational Leadership
296
11 Corporate Governance
301
STRATEGY IN FOCUS 11.1 Tata’s Governance
316
STRATEGY IN FOCUS 11.2 Sir Martin Sorrell: Pay and Performance at WPP
320
CASE EXAMPLE Fat Cats and Starving Dogs
324
Acknowledgements
At Oxford University Press, I would like to extend a special thank you to publishing editor, Kate Gilks, and all those
involved with the production and distribution of this book. I would like to thank copy-editor, Fiona Barry, proofreader,
Francesco Ingrao, and Prem Tiwari for managing the proofs. I would also like to thank the reviewers who provided
constructive comments. My foremost thanks are to my wife, Sue, for her encouragement and support.
Every effort has been made to trace and contact copyright holders but this has not been possible in every case. If notified, the publisher will undertake to rectify any errors or omissions at the earliest opportunity.
About the Author
Anthony Henry worked as a Market Analyst for HSBC in central London before joining
the university sector. He has experience working for public and private sector organizations, including Arthur Andersen. He has also counted traffic for a firm of transport
consultants, worked in a soap factory, and taught strategy in the UK and Germany
to global managers working for a FTSE-100 organization. He has worked as a Senior
­Lecturer in Strategic Management. In developing and teaching strategy modules
over several years, he has acquired a deep understanding of students’ needs, as well
as insights into how a textbook can be a powerful tool for successful teaching.
He recently spent seven years updating his business experience by working as a
senior manager in a medical company before returning to the university sector. His
appreciation of the business environment is used to enhance student understanding of the theory and practice of strategy. Anthony currently teaches strategy to undergraduate and MBA students at Aston University’s Business School.
About the Book
This third edition is a major update of the previous edition. It focuses on the aspects of strategy students encounter as
they seek to analyse, evaluate, and understand this topic. The pursuit of sustainable competitive advantage continues
as a key theme throughout the book. This is tempered by experience which suggests disruptive markets make competitive advantage ephemeral. Each chapter provides clear, robust, and practical discussions of the concepts students
encounter when studying strategy. The use of analysis, formulation, and implementation provides students with a
structure to understand the subject while making it clear the business world has a tendency to differ from neat, academic theories.
We not only discuss strategic concepts, frameworks, and analytical tools but, importantly, critique them. This encourages students to think analytically. Each chapter includes relevant business examples to facilitate student understanding. A few of the many changes in the third edition include a robust discussion of strategy in Chapter 1, grounded in
the business world. Chapter 3 and 6 include an assessment of disruptive innovation. In Chapter 4, there is an evaluation
of financial metrics. In Chapter 5, we evaluate dynamic capabilities as a means of dealing with the limitations of the
resource-based view of strategy. Chapter 10 includes the latest thinking on leadership, while Chapter 11 updates the
reader with the changes taking place in corporate governance. The existing literature on strategy is updated in every
chapter.
The majority of Case Examples and Strategy in Focus boxes are written by the author to provide students with a seamless transition from discussion to application. The third edition is comprehensive which allows a detailed study of strategy while its eleven chapters also facilitate shorter courses without sacrificing important strategy content. Guidance
on how to use this book and online resources is available to students in the next section.
Anthony E. Henry
January 2018
How to Use this Book
Chapter Maps
1.1 What is Strategy?
1.2 Strategic
1.2
StrategicManagement
Management
1.5 Changes in the Approach
to Strategic the
Management
Approach
Management
Extension Material
Organizations whose
l
i fl
th i
1.3 Vison, Values, and Mission
1.6 Different Perspectives
on 1.6
Strategy
DiffeFormulation
1.7 A Strategic Manag
Framework
on Strat
Extension Material
Theory of the business
d it i
t
H
Easily navigate through the key coverage and the online resources accompanying each chapter with these handy chapter
maps.
Extension Materia
Debate surrounding
d ’ d i ti
f
Learning Objectives
Learning
Learning Objectives
After completing this chapter you should be able to:
After completing this c
●
Explain what is meant by strategy
Explain
what
is mea
Comment
on the
role of values, vision, and mission in facilitating strategy
Describe theon
changes
● ●Comment
the roin the approach to strategy
●●
●
●
Identify different perspectives on strategy formulation
Develop a strategic management framework
STRATEGY IN FOCUS 1.1 Organizational Values at
STRATEGY
Clear, concise learning objectives outline the main concepts
and themes to be covered within the chapter. These lists will
help you review your learning and effectively plan revision, ensuring you have considered all key areas.
Strategy in Focus boxes
Johnson & Johnson: How their Credo Guides Strate
Johnson
&
General Robert Wood Johnson guided Johnson & Johnson from a small, family-owned business to
enterprise.
In doing
he had an enlightened view of a corporation’s responsibilities beyond the m
General
Robert
WoodsoJohn
and marketing of products. In 1935, in a pamphlet titled Try Reality, he urged his fellow industrialis
‘a new industrial philosophy’. Johnson defined this as the corporation’s responsibility to customer
the community, and stockholders.
Eight years later, in 1943, Johnson wrote and first published the Johnson & Johnson Credo
document outlining these responsibilities in greater detail. Putting customers first and stockho
a refreshing approach to the management of a business However Johnson was a practical bus
CASE EXAMPLE Intel’s Theory of the Business
CASE EXAMPLE
Andy Grove: Intel’s First Employee
ve: Intel’s
Firstwas
Employee
Andy Grove
born Andras Istvan Grof in Hungary, where he lived under both Nazi and late
occupation. He arrived in the United States in January 1957 and shortly after changed his nam
Stephen Grove. He acquired a Ph.D. in chemical engineering at the University of California at Be
joining Fairchild Semiconductor. In 1968, Gordon Moore, along with another executive, Robert No
child Semiconductor to found Intel. When Andy Grove heard they were leaving, he decided to go w
Grove recalls, ‘I never got an invitation’; he just went. At this time, there were many companies alr
hi
h l
i
h i
ll d
i Wh M
i
d
Learn from real-life situations in the business world with these
short illustrations taken from a range of contemporary news
sources, demonstrating how vital effective strategic management is to any business.
Case Examples
Applying the theoretical ideas from the chapter to a variety
of business situations, these extensive Case Examples, with
accompanying questions, encourage you to identify how
strategy works in a variety of international, wide-ranging, and
relevant business situations.
is always changing. To suc
Fora awider
wider
discussof the theory of the business and its impact on business strategy
For
discussion
online
resources
online
resources
and an
see the Extension Material for this chapter.
www.oup.com/uk/henry3e/
www.oup.com/uk/h
1.3.2 Business Models
The concept of business model is actually captured by Drucker in ‘the theory of the business’, disc
1.3.1. This is because a business model will include assumptions about markets, customers, and t
capabilities and weaknesses. Joan Magretta defines a business model as, a story which explains how
works.30 It answers questions posed by Drucker, such as: who is the customer? And, what does the c
Extension Material Signposts
If your course goes into extra depth on a specific topic or you
want more examples and discussion to aid your understanding,
follow the relevant signposts to Extension Material available online for additional coverage that builds seamlessly on the book.
How to Use this Book
For
moreinformation
information how to undertake scenario planning, go to the online resource
For more
the Working
through
Strategy feature for this chapter.
the
Working
throug
www.oup.com/uk/henry3e/
www.oup.com/uk/h
2.4 PEST Analysis
2 4 PEST An
A useful tool when scanning the macro-environment is PEST analysis. This refers to political, econ
technological factors. It is worth noting that some commentators include legal and environmental fa
preferring to extend the acronym to PESTLE. However, the legal element of the acronym can be subs
political factor. In addition, the use of the last E (which refers to environmental factors) is often me
Working through Strategy Signposts
To help you get a firmer handle on the essential tools of analysis, the Working through Strategy resources, available online,
are signposted wherever additional coverage and examples
of analytical tools and techniques are provided to further your
understanding.
Review and Discussion Questions
ReviewQuestions
Q
Review
What is
is strategy?
1.1.What
strategy?
Howdoes
does aastrategic
management framework aid our understanding of strategy?
2.2.How
strategic
Discussion Question
It is only companies which are not prepared to engage in rigorous analysis that have a vision. Discu
Reinforce your learning, aid your revision, and share ideas with
these end-of-chapter review and discussion questions covering the main themes and issues raised in the chapter.
Research Topics
Research
Research Topic
1.
2.
Identify organizations
1. Identify organizations in which clearly communicated values correlate with organizational su
Select
a combination
2.
Select
a combination of private- and public sector organizations and identify the extent to wh
mission
statement
sig
mission
statement signposts
to stakeholders what business they are in.
Recommended Reading
mission statement sign
Take your learning further and practise your researching skills
with these stimulating starting points for focussed research on
a specific topic or issue related to the chapter.
Recommended Reading
Recommen
Recommended Reading
● ● M.
‘Whatis strategy?’
is st
M.E.E.Porter,
Porter, ‘What
, Harvard Business Review, vol. 74, no. 6 (1996), pp. 61–78.
Rumelt, Good
● ● R.R.P.P.Rumelt,
GoodStrategy
Stra Bad Strategy, Crown Business, 2011.
For an insight into the debate on deliberate and emergent strategies, see:
●
●
R. T. Pascale, ‘Perspectives on strategy: the real story behind Honda’s success’, California Manag
vol. 26, no. 3 (1984), pp. 47–72.
H. Mintzberg, ‘The design school: reconsidering the basic premises of strategic management’, S
Management Journal, vol. 11, no. 3 (1990), pp. 171–95.
H I A ff ‘C iti
fH
Mi t b ’ “Th d i
h l
id i th b i
i
Glossary
Glossary
Glossary
A
A
Accounting profit – measures the difference between
the total revenue generated by the organization and its
total cost.
Acquisition (or takeover) – when one organization
seeks to acquire another, often smaller, organization.
Seminal books and journal articles that have contributed to the
field of strategic management are provided in an annotated
list at the end of chapters, offering the opportunity to read
around a particular topic, broaden your understanding, or provide useful leads for coursework and assignments.
Blue oceans – represents a strategic
competitors that has the potential fo
and highly profitable growth.
Business model – answers question
is the customer? And, what does the
It answers a crucial question for man
with how to make money from the b
A comprehensive glossary is provided at the end of the book to
check your understanding of key terms.
xxi
How to Use the Online Resources
This book is accompanied by a bespoke package of online resources that are carefully integrated with the text to assist
the learning and teaching of the subject. Students can benefit from extension material, multiple-choice questions,
web links, and exercises, while lecturers can make use of a question test bank, suggested answers to questions in the
book, and PowerPoint lecture slides.
Go to www.oup.com/uk/henry3e/ to find out more.
PART ONE
WHAT IS
STRATEGY?
1 What is Strategy?
3
CHAPTER 1
WHAT IS STRATEGY?
1.1 What is Strategy?
1.2 Strategic Management
1.5 Changes in the Approach
to Strategic Management
Extension Material
Organizations whose
values influence their
decision making
1.3 Vison, Values, and Mission
1.6 Different Perspectives
on Strategy Formulation
Extension Material
Theory of the business
and its impact
on business strategy
1.7 A Strategic Management
Framework
Extension Material
Debate surrounding
Honda’s domination of the
US motorcycle industry
Main Reference
Drucker, P.F. (1995). Managing in
a Time of Great Change . Butterworth
Heinemann, Oxford.
Learning Objectives
After completing this chapter you should be able to:
●
●
●
●
●
1.4 Types of Strategy
Explain what is meant by strategy
Comment on the role of values, vision, and mission in facilitating strategy
Describe the changes in the approach to strategy
Identify different perspectives on strategy formulation
Develop a strategic management framework
4
PART ONE What is Strategy?
1
Introduction
What is strategy? How is strategy formulated and implemented? Are values important in determining which markets
organizations seek to compete in? These are some of the questions that will be discussed in this first chapter. We start
the chapter with a discussion of what is strategy. There is general agreement that the purpose of strategy is to help
organizations achieve a competitive advantage. Where this consensus begins to break down is when we discuss how
competitive advantage is achieved. We will review different perspectives and the views of their chief advocates as we
discuss strategy formulation.
This chapter also looks at the co-dependent relationship between strategy analysis, formulation, and implementation.
We note that separating these elements may be useful for exposition but has limitations when seeking to explain strategy in practice. The role of an organization’s values, vision, and mission is explained as we discuss their importance
in setting strategic goals. We consider an organization’s assumptions about its competitive environment; its theory of
the business, and discuss how this can lead to organizational failure. We conclude the chapter by developing a strategic management framework which is a useful process in the search for competitive advantage. The framework is also
helpful for navigating subsequent chapters.
1.1 What is Strategy?
The use of strategy has existed for many centuries, although its use in management has a more recent history, dating
back about forty years. Strategy was born out of military conflicts and the use of a superior strategy enabled one warring party to defeat another. Carl von Clausewitz, writing in the nineteenth century, states that the decision to wage
war ought to be rational; that is, based on estimates of what can be gained and the costs incurred by the war.1 War
should also be instrumental; that is, waged to achieve some specific goal, never for its own sake, and that strategy
should be directed to achieve one end: victory. While policy makers may be unsure about what they expect from
modern military engagements, military personnel from commanders down to foot soldiers have only one question:
what is our objective in committing to a particular course of action? If the objective is unclear, they can expect the
formulation of strategy to be confused and its implementation to be unsuccessful.
In The Art of War, the Chinese philosopher and military strategist Sun Tzu wrote that victory occurs at headquarters
before even doing battle. It is based on whether you believe you can or cannot win. Sun Tzu believed strategic advantage was on the side of the leader who believed he could win before he even left headquarters.2 A good strategy can
defeat overwhelming obstacles. When Admiral Nelson engaged the French and Spanish fleet off the coast of Spain in
1805, he was outnumbered by their thirty-three ships to his twenty-seven.3 The standard rules of engagement at that
time was for opposing ships to do battle in parallel formation. Each ship would fire broadsides at its opposite number.
However, Nelson had other ideas.
He divided the British fleet into two columns and sailed them at the Franco-Spanish fleet, in order to engage them at
the perpendicular. Nelson surmised that the inexperience of the Franco-Spanish gunners would prevent them from
being able to deal with the great swell, while the experience of his own captains would enable them to take advantage
of the situation. The Franco-Spanish fleet lost twenty-two ships; the British lost none. Nelson correctly identified the
CHAPTER 1 What is Strategy?
5
In his history of strategy, Lawrence Freedman, recounts the battle between David and Goliath.4 The battle is often seen
as a youth, David, facing an overwhelming obstacle in the form of the giant, Goliath, who is a seasoned warrior. Yet, as
Freedman reminds us, David was not the underdog because he had God on his side. That said, the Israelite army was
frightened to face the challenge. The challenge Goliath put to them was that it was not necessary for the two armies to
engage in battle. Instead, they should choose a champion to fight him. If Goliath wins, Israel would be servants to the
Philistines but if Israel’s champion wins, the Philistines would serve Israel. This challenge was repeated every day for
forty days. Needless to say, the thought of facing a giant with oversized weapons brought forth no takers. The Israelite
army was paralysed with fear.
When King Saul heard there was a man prepared to face the giant he wanted to meet him. David was a shepherd boy,
the youngest in his family. His older brothers were already in the army, but like everyone else, they were not prepared
to face the giant. King Saul offers David the king’s armour and weapons, but as David is much smaller than the king
he’s unable to move around in them. Instead, he takes five smooth stones from the brook and goes to face Goliath. He
puts one stone in his sling and runs towards Goliath, hurling the stone from the sling. The stone sinks into the giant’s
forehead, causing him to fall facedown; David draws the giant’s sword and kills him. The use of surprise tactics and an
unexpected rule of engagement, allowed David to defeat a superior foe.
We need to exercise caution in drawing military analogies. Unlike war, in the modern business arena organizations are
increasingly aware of the benefits of cooperation as well as competition.
There is agreement that the role of strategy is to achieve competitive advantage for an organization. Competitive
advantage is the configuration of an organization’s activities which enable it to meet consumer needs better than its
rivals. Its source derives from the discrete activities that a company performs when it designs, produces, markets, delivers, and supports its product or service. If a competitive advantage is to be sustainable, however, the advantage must
be difficult for competitors to imitate. As Bruce Henderson points out, ‘Your most dangerous competitors are those
that are most like you. The differences between you and your competitors are the basis of your advantage.’5
The use of strategy is the primary way in which managers take account of a constantly changing environment. An
effective strategy allows managers to use the organization’s capabilities to exploit opportunities and limit threats in
the environment. A debate arises when we try to pin down what is strategy and, importantly, how strategy is formulated. This discussion has continued unabated for decades and is rooted in a desire for managers to undertake better
strategic thinking and therefore better strategic decisions.
Strategy can be defined in a number of different ways. However, we should be aware that any definition is likely to
be rooted within the different perspectives adopted by its adherents. For this reason, a definition of strategy which is
accepted by everyone, is not as straightforward as might first appear. As individuals, we all devise strategies to help us
achieve certain goals. For instance, consider a couple on a long journey with two young children under five in the back
of the car. Do they set off early because this will beat the traffic congestion and make sense because the toddlers rise
early? Or, do they leave in the evening at the children’s bedtime when they will hopefully sleep for the entire journey,
giving Mum and Dad a much-needed break? Do they take the main roads in the hope of cutting the journey time but
1
crucial issues in this particular battle which allowed the actions of his fleet to be multiplied. The Battle of Trafalgar was
to be Britain’s greatest naval battle.
6
PART ONE What is Strategy?
1
with the downside of congestion, or take less travelled roads, which avoid traffic jams but may take longer? What this
emphasizes is that strategy is all about choice. At the organizational level the choices and trade-off are extremely
complex.
1.1.1 Defining Strategy
Harvard professor, Michael Porter, asserts that strategy is about being different. It requires a company to choose a
different set of activities to undertake than its competitors. All companies incur costs as a result of the many activities
they undertake in order to be able to design, manufacture, market, and distribute their products or services. It is these
activities which form the basis of competitive advantage. Therefore, a company must choose activities in which it can
deliver a unique mix of value to the consumer.6
A company can only outperform its rivals when the value it provides to the consumer is difficult for them to imitate.
This occurs when: (1) the company provides a differentiated product or service which is more highly valued by customers, enabling it to charge a premium price; or (2) the company provides products with the same quality as a competitor
offering, but charges a lower price. In other words, it acquires a cost advantage by undertaking certain activities more
efficiently than its competitors. This, in turn, allows the company to charge a lower price.
In contrast, operational management is about performing similar activities better than your competitors. It includes
tools such as total quality management, benchmarking, outsourcing, and business process re-engineering. It is primarily a search for efficiency, but includes any practice that allows a company to better utilize its inputs. For example,
this might be developing better products faster than your competitors.
Constantinos Markides argues that the essence of strategy is for an organization to select one strategic position that it
can claim as its own.7 A strategic position represents a company’s answers to the following questions:
●
Who should the company target as customers?
●
What products or services should the company offer the targeted customers?
●
How can the company do this efficiently?
In this way, a company can achieve success by choosing a strategic position which differs from the competitors in its
industry. The economist, John Kay, views the strategy of an organization as ‘the match between its internal capabilities and its external relationships’. That is, a company’s strategy describes the match between what it is particularly
good at doing and its relationship with its customers, suppliers, and competitors.8 This is because organizations are
part of a network of relationships. To succeed, they must deal with customers and suppliers, with their competitors
and potential competitors. These relationships may be contractual—based on precise, legal documentation—or,
they may be relational—that is, based on the need the parties have to continue doing business together. It is the
unique structure of these relationships, which Kay refers to as architecture, which can be a source of a firm’s competitive advantage.
If strategy is construed as the relationship between an organization and its environment, then it can be disaggregated
from operational management issues. For example, strategy is not primarily concerned with every aspect of business
behaviour such as an employee motivation, accounting, and inventory control. That’s not to say these cannot influence
the strategy or be influenced by the strategy. It is the difference between these elements of management and strategy
CHAPTER 1 What is Strategy?
7
However, when we seek to understand strategy, we see it is different. For example, the success of BMW and Honda
is based on their ability to recognize their distinctive capabilities, what each can do better than other organizations, and compete in the markets which exploit these capabilities. They do not build on the best practice of their
competitors. In fact, when they tried to copy their competitors they failed. Therefore, successful strategy is based on
doing well what your competitors cannot do or cannot easily do. It is seldom based on what your competitors can do
or are already doing. An effective strategy will be adaptive and opportunistic; this is not to imply anything vague and
unfocused. Strategy is about the firm using analytical techniques to help it understand, and therefore influence, its
position in the market.
Richard Rumelt laments that over time strategy has become confused by researchers, consultants, chief executive
officers (CEOs), and just about anybody, equating it to mean whatever they want. The concept strategy is erroneously
equated with success, determination, ambition, inspirational leadership, and innovation. However, strategy is more
than just urging an organization forward towards a goal or vision. A strategy should honestly acknowledge the challenges being faced by an organization. In addition, a strategy should also provide an approach to overcome the challenges. As such, strategy is about discovering the critical factors in a situation and providing a way to coordinate and
focus action to deal with these factors. In his book, Good Strategy Bad Strategy, he describes a good strategy as having
an essential logical structure which he calls the kernel.9 The kernel of a strategy contains three elements: a diagnosis, a
guiding policy, and a coherent set of actions.
1. A Diagnosis
A diagnosis defines or explains the nature of the challenge which faces the organization. The purpose of a
diagnosis is to simplify the complexity of the situation facing the organization. This is done by identifying which
aspects of the situation are critical. An insightful diagnosis can transform a manager’s view of the situation. It
might classify the situation according to a certain pattern; this then guides managers to think how a similar pattern was handled by the organization in the past.
2. A Guiding Policy
This is the overall approach which managers have chosen to deal with the obstacles identified in the diagnosis. It
is a guiding policy because it directs management action in certain directions, but does not tell managers exactly
what they should do. It provides a method in which managers can deal with a situation, and also rules out numerous other actions.
3. A Set of Coherent Actions
Strategy is about action; in order to be effective, it must be achieving something. Therefore, a set of coherent actions
is necessary to carry out the guiding policy. It is not necessary to know all the actions that are to be undertaken as the
events unfold. What is needed is sufficient clarity on what actions are required to focus the organization’s attention.
These actions are the steps which are coordinated to work together to accomplish the guiding policy. In reality, many
organizations try to avoid making the difficult choices that emanate from strategy, but this only results in inaction.
When leaders in an organization engage in diagnosis, what initially appears as an overwhelming complex situation is replaced by a simpler story. This allows everyone who is involved with the problem to make sense of the
1
which helps explain the nature of strategy. Many organizations in our industry may possess good quality human
resources, effective accounting practices, and technology suited to their needs. When one organization succeeds in
these endeavours it is not detrimental to others. Other organizations can simply copy best practice in the industry.
8
PART ONE What is Strategy?
1
situation. This, in turn, allows progress to be made in further problem-solving. This helps to define what type of action
is required.
An organization is faced with a constantly changing environment and needs to ensure that its internal resources and
capabilities are more than sufficient to meet the needs of the environment. Organizations do not exist simply to survive
in the marketplace, but want to grow and prosper in a competitive environment. In order to make sense of what is going
on around them, managers must analyse the capabilities inside their organization and the needs of the environment.
An organization’s environment comprises the macro-environment and the competitive environment. The general or
macro-environment consists of factors which may not have an immediate impact on the firm, but have the capacity
to change the industry in which the firm competes, and even to create new industries. The competitive environment
deals with the industry in which the firm competes. If an organization is to achieve superior profitability, it needs
to achieve a competitive advantage over competitors in its industry. Changes within an organization’s competitive
environment, such as an increase in the number of competitors, will have a far more immediate impact on the organization. The tools for analysing the environment are considered in detail in Chapters 2 and 3. The analysis of the organization includes its values, goals, resources and capabilities, and internal structure. The values that the firm embodies
will guide its choice and the implementation of strategic goals. An organization’s values are particularly important for
providing guidance to deal with crises (see Strategy in Focus 1.1 on Johnson & Johnson). We will consider different
approaches to analysing the organization in Chapters 4 and 5.
1.2 Strategic Management
A strategy allows an organization to configure its resources and capabilities to meet the needs of the environment to
achieve competitive advantage. The process of undertaking a strategy is strategic management. All organizations set
goals they want to achieve. Strategic management is about analysing the situation facing the firm. This analysis will
allow managers to formulate strategies for dealing with the situation or challenge facing the company. The analysis
will invariably produce more than one strategy that can be adopted. Therefore, managers are faced with a choice of
which strategy they decide to implement. The end result is for the organization to achieve competitive advantage over
its rivals in the industry.
A point worth noting is that these elements are co-dependent; that is, in formulating a strategy an organization must
also consider how that strategy will be implemented. Failure to consider the coordination of strategy will decrease the
likelihood of success. We might also note that a neat sequential pattern may not resemble how a given organization
might undertake strategic management. Figure 1.1 illustrates the interdependent relationship between analysis,
formulation, and implementation. It is often said that analysis is easy; implementation is the difficult part. However,
Strategy
Analysis
Strategy
Formulation
Strategy
Implementation
Figure 1.1 The interdependent relationship of analysis, formulation, and implementation.
CHAPTER 1 What is Strategy?
9
For example, some organizations might actually implement a strategy without fully analysing their current situation.
This may be because events in their industry are changing so fast that they feel they simply do not have the luxury of
undertaking detailed analysis. An organization’s leader might take a series of decisions based on experience or intuition. In reality, without the use of some analysis managers will never know why a strategy succeeds and what they can
learn from this. They will not fully understand how it meets the industry’s key success factors. Key success factors
are those elements in the industry that keep customers loyal and allow the organization to compete successfully. By
analysing what consumers want and the basis of competition in the industry, an organization is able to ascertain the
key success factors for its industry. For instance, it might ask: which elements of its resources and capabilities brought
it success? What was the role played by its internal structure and organizational culture? What factors drive competition in this industry? In short, without analysis its success will likely be short-lived and difficult to repeat.
1.2.1 Strategy Analysis
Whilst bearing in mind that the strategic management process is co-dependent, the undertaking of strategy analysis
by the organization is a useful starting point. Strategic analysis deals with the organization; it allows managers to evaluate how well the company is positioned to exploit opportunities and mitigate threats. As we shall see in C
­ hapters 2
and 3, this also involves an analysis of the macro-environment and the industry.
1.2.2 Strategy Formulation
A careful analysis of the organization and the needs of the environment will allow managers to assess where they can
best achieve a strategic fit between the two. Without some form of analysis, decisions can only be based on experience. Experience alone may have been fine in the stable industries of the past, but in today’s dynamic environments
managers cannot expect to follow today’s patterns tomorrow. However, Henry Mintzberg reminds us that strategy
formulation also occurs as a creative and, at times, subconscious act which synthesizes experiences to form a novel
strategy.10 Similarly, Kenichi Ohmae accepts that strategic thinking starts with analysis, but stresses creative insight in
the formulating of great strategies. Such insight does not form part of any conscious analysis.11
Markides argues that effective strategy formulation is a process of continuously asking questions. In this process, how
a question is formulated can be more important than finding a solution.12 Ohmae makes a similar point. He states that
a vital part of strategic thinking is to formulate questions in a way that will help find a solution. A key part of strategy formulation is strategy evaluation which recognizes that an organization is seldom faced with one strategy, but
requires a criterion to judge competing strategies.13 Rumelt contends that the essential difficulty in creating strategy
is choice. This is because strategy does not eliminate scarcity, and a consequence of scarcity is you have to make a
choice.14 A common reason for poor strategy is that leaders are unwilling or unable to make choices between competing groups and different solutions.
Strategy formulation primarily takes place at two different levels within the organization: the business level and the
corporate level. Business and corporate strategies are addressed in detail in Chapters 6 and 7. For now we can say
1
such thinking fails to realize the importance of analysis in understanding the challenges facing the firm. Analysis,
formulation, and implementation all need to be considered if the organization’s strategy is to meet the needs of its
environment effectively.
10
PART ONE What is Strategy?
that corporate strategy deals with the fundamental question of what markets the company wants to compete in,
whereas, business strategy deals with how a company competes in its chosen markets.
1
1.2.3 Strategy Implementation
The best-formulated strategy will amount to nothing if it is poorly communicated and coordinated throughout
the organization. Effective implementation of strategies requires the organization to be sufficiently flexible in its
­organizational structure and design. Strategies need to be communicated, understood, and properly coordinated
with stakeholders inside and outside the organization. In an age of collaboration, this may involve discussions with
key suppliers and partners. Although the leader of an organization will ultimately be responsible for a strategy’s success or failure, their role should be to encourage and create an organizational culture which empowers managers to
respond to opportunities. In this way, each employee will be confident to try out new ideas and innovate without fear
of reprisals. The values of an organization will be important here.
At a fundamental level we can ask: what is the purpose of any organization? Why does it exist? These questions are
relevant irrespective of whether an organization operates in the private, public, or voluntary sector. This is because all
organizations must have a clear sense of direction if managers are to understand what they are seeking to achieve. For
example, organizations in the private sector may seek to maximize returns to shareholders; and firms in the public
sector may want to utilize their resources in an optimal manner. Strategy is simply the way in which an organization
bridges the gap between its stated goals and how it intends to achieve them. Often purpose and goals are used
interchangeably, but this misses an important distinction between the two: the goals that leaders set derive from a
company’s purpose. The purpose is the reason an organization exists. This will become more clear as we look at the
purpose of organizations and how this guides their strategy.
1.3 Vision, Values, and Mission
A vision is often associated with the founder of an organization and represents a desired state that the organization aspires to achieve in the future. In contrast with goals, a vision tends not to change over time. A vision must tap
into the personal goals and values of the organization’s employees if it is to be internalized by them. When it bears
little resemblance to reality, disregards the capabilities of the organization, and the problems of the organization,
it will be rejected by employees. Employees will also reject a vision where they see a credibility gap between
managers’ rhetoric and their actions. In other words, leaders must be ‘authentic’.15 The prerequisite for producing
a vision is not great intellect, but imagination, intuition, and an ability to synthesize disparate information. The
length and complexity of vision statements differ between organizations, but clearly, they must be easy to understand and remember.16
The use of a vision is not without its problems. Rumelt is critical of what he calls ‘template style strategy’, where organizations simply fill in their unique vision of what the business will be like in the future.17 Popular visions include being
‘the best’ or ‘the leading’. Enron’s vision was ‘to become the world’s leading energy company’. Similar template-style
strategies are applied to the mission and the values of the organization. A company will describe its values, making
sure they are noncontroversial. For example, Enron’s values were ‘integrity, respect, communication and excellence’.
Consultants, in particular, have found that template-style strategy obviates the need for the difficult work of analysing
CHAPTER 1 What is Strategy?
11
An organization’s mission seeks to answer the question why an organization exists. A mission statement can be defined
as a way in which the organization communicates the business it is in to the outside world. Peter Drucker argues that a
mission statement is the same as asking the question ‘What business are we in?’18 A mission statement needs to appeal
to a broad spectrum of stakeholders if all stakeholders are to accept it. Stakeholders are those individuals or groups
which can affect or are affected by the achievement of an organization’s goals.19 In this respect, a mission statement
which simply exhorts the need to maximize shareholder value will be unlikely to motivate employees.
It is not unusual, particularly in the public sector, for organizations to have mission statements at different levels ranging from a department all the way down to individual teams. If these statements are to guide employee behaviour,
then it would seem that two conditions are necessary: (1) such statements are communicated clearly to all employees;
(2) those employees internalize these statements and use them to direct their behaviour. The use of these statements
may constitute a necessary, but not sufficient condition for organizational success. At some point, like Rumelt, we
might ask what actually is being accomplished as a result of vision and mission statements.
Andrew Campbell and his colleagues20 make a distinction between an organization’s mission and its sense of mission.
They see a mission as an intellectual concept that can be used to guide the policies of an organization. However, a
sense of mission is an emotional commitment that employees feel towards the organization. It occurs when employees feel that there is a match between the values of an organization and those of the individual. The key point is that
individuals with a sense of mission are emotionally committed to the organization, what it stands for, and what it is
trying to achieve.
In their quest for what makes a visionary organization, Jim Collins and Jerry Porras describe a core ideology made
up of core values and purpose.21 The core values are an organization’s essential and enduring tenets, which will not
be compromised for financial expediency and short-term gains. They do not shift as competitive conditions change,
but remain largely inviolate. It is what members are expected to endorse and internalize as part of working for such
organizations. More than that, it is what attracts individuals to these types of organizations in the first place. IBM’s
former chief executive officer, Thomas J. Watson Jr, stated that for any organization to survive and achieve success, it
must have a set of beliefs on which all its policies and actions are based. ‘The most important, single factor in corporate
success is faithful adherence to those beliefs.’22
A similar point was made by the founder of Johnson & Johnson, Robert Wood Johnson, when he wrote the organization’s credo or set of beliefs in 1943. Unusually for this time, Johnson explicitly recognized the importance of meeting
stakeholder needs. Stakeholders, as we noted, are those individuals and groups upon whom the organization depends
to achieve its goals. Stakeholders, in turn, have an interest in and can influence the success of the organization. They
include customers, suppliers, shareholders, employees, and the local community, among others. Johnson believed
that service to customers should always come first, service to the organization’s employees and management should
be second, the local community third, and lastly service to shareholders. Johnson recognized that shareholders will
receive a fair return only when the preceding elements are aligned. See Strategy in Focus 1.1, which illustrates how
Johnson & Johnson’s guided their executive management decisions some forty years later when they were faced with
a crisis.
1
the challenges and opportunities faced by their client. Also, by placing strategy in positive concepts such as vision,
mission, values, it is unlikely to upset anyone.
12
PART ONE What is Strategy?
STRATEGY IN FOCUS 1.1 Organizational Values at
1
Johnson & Johnson: How their Credo Guides Strategy
General Robert Wood Johnson guided Johnson & Johnson from a small, family-owned business to a worldwide
enterprise. In doing so he had an enlightened view of a corporation’s responsibilities beyond the manufacturing
and marketing of products. In 1935, in a pamphlet titled Try Reality, he urged his fellow industrialists to embrace
‘a new industrial philosophy’. Johnson defined this as the corporation’s responsibility to customers, employees,
the community, and stockholders.
Eight years later, in 1943, Johnson wrote and first published the Johnson & Johnson Credo, a one-page
document outlining these responsibilities in greater detail. Putting customers first and stockholders last was
a refreshing approach to the management of a business. However, Johnson was a practical businessman. He
believed that by putting the customer first the business would be well served, and it was. Johnson saw to it that
his company embraced the Credo, and he urged his management to apply it as part of their everyday business
philosophy.
In 1982 Johnson & Johnson faced a crisis. A drug, Tylenol, from one of its operating companies, was altered
and cyanide placed in the capsule form of the product. This resulted in seven deaths. Johnson & Johnson’s
strategic response was inspired by the philosophy embodied in the Credo. The product was voluntarily recalled
and destroyed, even though testing found the remaining capsules to be safe. Johnson & Johnson took a $100
million charge against earnings. In 1986, as a result of a second tampering incident and another fatality,
Johnson & Johnson took the decision to discontinue the sale of Tylenol in capsule form. The operating company
reintroduced Tylenol in tamper-proof packaging and regained its leading share of the analgesic market. Faced
with the loss of millions of dollars, the values that are embodied in Johnson & Johnson’s Credo guided its strategic
response and ensured that its quick and honest handling of the crisis preserved the company’s reputation.
Tylenol, as it looks today. Source: © digitalreflections/Shutterstock.com
When Robert Wood Johnson wrote and then institutionalized the Credo within Johnson & Johnson, he never
suggested that it guaranteed perfection. But its principles have become a constant goal, as well as a source of
inspiration, for all who are part of the Johnson & Johnson Family of Companies.
Source: Adapted from www.johnson&johnson.com
Johnson & Johnson provides a classic example of how an organization’s values guide its behaviour. This example
demonstrates the importance of values in guiding how an organization decides and implements its strategy. It
is the values of an organization which form and shape the corporate culture over time. This, in turn, provides a
signpost for what is acceptable behaviour. For example, as organizations continue to outsource activities overseas
in search of cheaper manufacturing, they must ensure that employee conditions conform to their own organizational values. The use of child labour in some countries has forced organizations to face up to a credibility gap
between their rhetoric and their deeds. The more robust the values in an organization are, the greater the clarity
this provides for setting goals and therefore strategic direction and action. The more ambiguous the values within
an organization are, the greater the opportunity for conflicting goals and for decisions to go unchallenged. It is
interesting to reflect on the values which exist within financial institutions, such as Royal Bank of Scotland and
Lehman Brothers, which contributed to the global financial crisis. A discussion of values is dealt with in greater
detail in Chapter 9.
Purpose represents the reasons an organization exists beyond making a profit. The purpose of an organization is distinct from its goals and strategies. Its primary function is to guide and inspire individuals. A purpose should be broad,
fundamental, and enduring in its composition. It should be capable of being stated succinctly. A purpose is comparable to a vision in that organizations never achieve their purpose; it is an ongoing journey. For example, the American
pharmaceutical company Merck, has its stated purpose as: ‘we are in the business of preserving and improving human
life. All our actions must be measured by our success in achieving this.’23 In an address to members of Hewlett-Packard,
its co-founder, David Packard, outlined his company’s purpose as follows:
I think many people assume, wrongly, that a company exists simply to make money. While this is important . . . the
real reason for our existence is that we provide something which is unique [that makes a contribution].24
The challenge for organizations is how to preserve what is their very essence but still respond to a changing competitive environment. Collins and Porras suggest the use of BHAGs to stimulate progress. BHAGs are Big Hairy Audacious
Goals.25 A BHAG is clear and compelling, and it serves as a rallying cry to all employees as to where their energies should
be focused. It has a finite time span so that everyone knows when it is achieved. Such goals include President John
F. Kennedy’s commitment to landing a man on the moon and returning him safely to earth before the decade was
out. BHAGs are easy to understand, and no matter how many different ways they may be put, they are still understood
by everyone.
In 1907, Henry Ford proclaimed that he wanted to democratize the automobile and ‘build a car for the great multitude
. . . so low in price that no man making a good salary will be unable to own one’.26 At that time Ford was one of over
thirty car companies competing in this emerging market. It succeeded, but its success was short-lived. This highlights
a couple of important points to bear in mind with BHAGs. First, they must fit with an organization’s core ideology; this
was the case with Ford. Second, once achieved they need replacing. Ford achieved its BHAG, but did not set another.
This allowed General Motors to supplant its dominant position in the automobile industry.
For more information on organizations whose values influence their decision making, visit the
online resources and see the Extension Material for this chapter.
www.oup.com/uk/henry3e/
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PART ONE What is Strategy?
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1.3.1 The Theory of the Business
Drucker contends that organizations encounter difficulties when the assumptions on which they are built and the
basis on which they are being run no longer fit reality. These assumptions affect management behaviour and their
decisions about what and what not to do. They also determine what managers believe are meaningful results. They
include assumptions about markets, customers, competitors, and the organization’s capabilities and weaknesses.
Drucker refers to this as a company’s theory of the business.27
Every organization has a theory of the business, regardless of whether it operates in the public, private, or not-forprofit sector. The reason many large corporations are no longer successful is that their theory of the business no longer
works. For example, when the computer was in its infancy IBM’s theory of the business suggested that the future of
computing was in mainframes. Around this time the first personal computer was developed by enthusiasts. At the
same time as serious computer makers were reminding themselves that there was absolutely no reason for personal
computers, the Apple and the Macintosh went on sale, starting the PC revolution.
An organization’s theory of the business has four characteristics. (1) The assumptions about the environment, mission,
and core competencies must fit reality. Simon Marks, the co-founder of Marks & Spencer, realized that continued
success in his business meant that he as merchant should develop new core competencies. He would design products
based on his customer knowledge, and find manufacturers to make them to his costs. This went against the established practice of manufacturers producing products they thought the consumer might buy. (2) The assumptions in
all three areas have to fit one another. (3) The theory of the business must be known and understood throughout
the organization. This is relatively easy when an organization is founded, but as it grows it must be reinforced if the
organization is not to pursue what is expedient rather than what is right. (4) The theory of the business has to be continually tested.
In effect, the mental model a manager holds about an organization must be subject to change if the organization is to
meet changing market conditions and survive. This was the challenge facing Intel CEO Gordon Moore and his senior
manager, Andy Grove. The rivalry from Japanese competitors willing to compete aggressively on price threatened
Intel’s core memory chip business. Grove and Moore were faced with difficult choices about the company’s future. See
Case Example: Intel’s Theory of the Business.
Drucker argues that every theory of the business will eventually become obsolete and no longer meet the needs of the
organization. However, there are two preventive measures. The first is abandonment: every three years a company can
look at its markets, products, and policies and ask itself: if we were not already in it, would we still want to be in it now?
This was the question which the CEO of Intel, Andy Grove, put to his chairman, Gordon Moore before they exited the
market for memory chips.28 Of course, given the nature of dynamic environments, a more realistic timescale might be
every year. Nonetheless, this forces managers in organizations to question the assumptions on which their business is
based—their theory of the business.
The second preventive measure is to study what is happening outside the business, especially with non-customers.
This is because fundamental change rarely happens within your own industry or with your own customers. For example, satellite navigation equipment manufacturers did not perceive mobile phones as a competitor. However, the
CHAPTER 1 What is Strategy?
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A theory of the business becomes obsolete when an organization has achieved its original objectives. As with the
example earlier of Ford democratizing the automobile, the achievement of the objective may point to the need for
new thinking, rather than be a cause for celebration. As Sam Walton, the founder of the American retailer Wal-Mart,
which owns the UK retail Asda, noted: ‘You can’t just keep doing what works one time, because everything around you
is always changing. To succeed you have to stay out in front of that change.’29
For a wider discussion of the theory of the business and its impact on business strategy visit the
online resources and see the Extension Material for this chapter.
www.oup.com/uk/henry3e/
1.3.2 Business Models
The concept of business model is actually captured by Drucker in ‘the theory of the business’, discussed in Section
1.3.1. This is because a business model will include assumptions about markets, customers, and the organization’s
capabilities and weaknesses. Joan Magretta defines a business model as, a story which explains how an organization
works.30 It answers questions posed by Drucker, such as: who is the customer? And, what does the customer value? It
answers a crucial question for managers who are concerned with how to make money from the business. What is the
economic logic which explains how we can deliver value to customers at an appropriate cost?
A good business model remains essential to every organization, whether it’s a start-up or an established company.
Although every viable organization is built on a sound business model, a business model isn’t a strategy, even though
the terms are often used interchangeably. A business model describes how the activities of a business fit together;
its value chain. It includes all the activities associated with making a product; for instance, design, manufacturing,
and purchasing. It also includes the activities associated with selling a product or service; for instance, transactions,
distribution, and delivery. A business model describes how the organization operates, whereas a business strategy
explains how an organization can compete better than its rivals. Therefore, a business model should complement a
clear competitive strategy.
If a business model is to remain relevant, managers must be open to innovations.31 Organizations are being
encouraged to take an interest in business model innovation for three reasons. First, product life cycles are
­getting shorter, and this faster pace of change is leading managers to look for the next big thing. Second,
competition can come from unexpected sources; we saw earlier that satellite navigation equipment manufacturers did not perceive mobile phones as a competitor. Third, disruptions from a competitor’s business model
can offer the consumer better experiences and products more suited to their needs. It is crucial that managers are able to perceive when their business model may be becoming obsolete. A business model will likely
require change when each successive innovation offers smaller and smaller improvements to the product or
service. And also, when your customers are conveying to you that competitor offerings are increasingly acceptable to them.
1
inclusion of free satellite navigation apps on mobile phones had a devastating effect on the market for satellite navigation equipment. This type of change invariably first manifests itself with your non-customers. We will say much more
on detecting changes that might impact the competitive environment in Chapter 2.
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PART ONE What is Strategy?
1
1.4 Types of Strategy
There are three basic forms of strategy which interest organizations. These are corporate strategy, business strategy,
and functional or operational strategy. In reality, most organizations are concerned with business strategy and corporate strategy.
1.4.1 Corporate Strategy
Corporate strategy is concerned with the broader issue of which industries the organization wants to compete in.
Corporate strategy deals with mergers and acquisitions and the allocation of resources between the organization’s
strategic business units (SBUs). A strategic business unit is a distinct part of an organization, which focuses upon a
particular market or markets for its products and service. Unilever’s takeover of Dollar Shave Club is part of its corporate
strategy of moving into the market for razor blades, where it had no presence. Intel’s move away from memory chips
and into microprocessors was corporate strategy. Corporate strategy is often seen as the preserve of the most senior
management within an organization.
1.4.2 Business Strategy
Business strategy, sometimes called competitive strategy, deals with how an organization is going to compete within
a particular industry or market. It is concerned with how the organization will achieve a competitive advantage over
its rivals. In contrast to corporate strategies, managers of SBUs, are usually given substantial autonomy to formulate
business strategies. Business strategy is dealt with in Chapter 3, when we assess industry analysis, and Chapter 6.
1.4.3 Functional/Operational Strategy
We might note that there is a third category: functional strategy. This deals with decisions according to functional
lines such as research and development (R&D), marketing, and finance. These functions will be involved in the
support of the business strategy. Sometimes this is referred to as operational strategy. However, operational strategy is a misnomer because it simply means managers taking decisions to implement business strategy. A more
appropriate term would be operational management. Therefore, we will subsume this within business strategy in
our discussions.
1.5 Changes in the Approach to Strategic
Management
We have seen that strategic management is concerned with how firms achieve and sustain competitive advantage.
However, a major disagreement arises when we look at how competitive advantage is achieved by the firm. The true
test of how organizations achieve and sustain competitive advantage is ultimately decided in the marketplace. Therefore, one might expect research to provide an answer. Even here, there is disagreement, as research findings are both
accepted and contested.
The changes in strategic management as a discipline reflect the changing dynamics of modern economies. It began
in the 1960s when organizations could rely on stable and expanding market conditions with a customer emphasis on
price. Under such conditions it was natural that strategy was largely equated with corporate planning. It was not unusual for major corporations to have a corporate planning function or department which annually developed long-term
plans for the next five years, and even longer in some instances. These were primarily finance-based budgetary control
systems, giving the assurance that there was some scientific basis to this kind of planning. In times of relative stability,
which in turn provides for some degree of predictability, this type of corporate planning was to be expected.
In the 1970s the corporate landscape was focused on diversification, in particular how to increase market share by
capturing new markets. Igor Ansoff’s growth vector matrix explains how organizations can engage in related and
unrelated diversification to increase their market shares.32 Diversification works well as long as synergies ensue, resulting in increased profitability and an increase in the capital value of the firm. It also presupposes that management has
sufficient skills and capabilities to run businesses operating in markets of which they may have little or no knowledge.
We will say more about this in Chapter 8.
In the 1980s, the work of Michael Porter on industry analysis shifted the emphasis to firms analysing the competitive
forces inherent within their industry as a means of gaining competitive advantage. Porter argues that firms should
position themselves favourably against adversarial forces within their industry and adopt a strategy that would
enable them to compete effectively.33 In the 1980s corporations had also begun to focus on the core elements of
their businesses. This was a period in corporate history in which managers were encouraged to stick to the knitting,
as exemplified in Peters and Waterman’s best-selling book In Search of Excellence.34 At the same time, Mintzberg was
proposing that strategy does not only involve intention, but can also develop as part of an emerging process. In other
words, an organization may have achieved success without going through the process of analysis, formulation, and
implementation.
Different perspectives on strategy continued throughout the 1990s as new management techniques taught corporate leaders about downsizing, outsourcing, delayering, total quality management, economic value analysis,
benchmarking, and re-engineering. Organizations were outsourcing all but the essential elements, or the core
competences, of the organization. In contrast with Porter’s work, the resource-based view (RBV) of the firm—
exemplified by the work of Robert Grant,35 John Kay,36 and C. K. Prahalad and Gary Hamel,37 among others—exhorts
the organization to look within itself at its resources and competences as the basis for competitive advantage.
The RBV approach contends that market positioning will only provide temporary competitive advantage, since
any successful position will be copied. Despite the disagreement between Porter’s positioning approach and the
resource-based view of strategy, Raphael Amit and Paul Schoemaker see RBV as a complement to industry analysis.38
This is because industry analysis views the sources of profitability to be the characteristics of the industry and the
firm’s position within the industry, while the resource-based view see the determinants of profitability as the firm’s
resources and capabilities.
Richard D’Aveni coined the term hypercompetition to describe a new competitive situation where firms must continually innovate, developing new products or services for the customer. For D’Aveni, sustainable competitive advantage now requires firms to constantly develop new products to provide customers with increased functionality and
performance.39 Microsoft is an example of a hypercompetitive firm which is forced to cannibalize its existing product
each time it introduces new software. See Chapter 3 for a discussion of hypercompetition.
17
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PART ONE What is Strategy?
However, not everyone is convinced that hypercompetition represents a new framework for understanding competition. For example, Porter argues that hypercompetition can be seen as an excuse for a lack of managerial ability and
poor strategic thinking.40 Furthermore, Mintzberg argues that turbulence, inasmuch as it exists at all, is an opportunity
for organizations to learn from a changing environment, as the Japanese have done.41 Mintzberg is not denying turbulence per se; he is simply pointing out that there is a tendency in strategic management to characterize the previous
decades as stable, and our current decade as turbulent. Research by Gerry McNamara and his colleagues seems to
support Mintzberg, as they suggest that ‘hypercompetition perspectives are important but no more so now than they
were in recent years’.42
In the 1990s organizations began to see the benefits of collaboration, cooperation, and joint alliances. ‘Networking’
between corporations became the new buzzword. Supplier relationships were seen as a source of competitive advantage, and not as one of competition. Adam Brandenburger and Barry Nalebuff refer to this détente as co-opetition,
that is, a blend of competition and cooperation existing simultaneously, in effect a non-zero-sum game.43 This is discussed in detail in Chapter 3. In the twenty-first century the ascendency of the resource-based view and development of dynamic capabilities continues.44 Dynamic capabilities imply an ability for an organization to develop new
capabilities as old ones become less effective and no longer unique. If the capabilities of the organization co-evolve
with the market, it maintains a dynamic fit between internal and external conditions.45 As such, dynamic capabilities
may allow an organization to sustain competitive advantage rather than rely on market barriers for advantage. This is
discussed in detail in Chapter 5.
Another approach to strategic management is chaos and complexity theory, which eschews the linear tradition. Drawing upon the natural sciences, organizations are seen as non-linear feedback loops which link to other organizations
(or families) by similar loops. Organizations operate far from the equilibrium state of neo-classical economics, between
the borders of stability and instability. This implies that in the short term some control is possible, but over time, linear,
rational approaches to decision-making may be insufficient to meet the context in which organizations operate.46
1.6 Different Perspectives on Strategy Formulation
The issue of how strategy is actually formulated has led to claims and counterclaims about the merits of different
schools of thought within strategic management. This ongoing debate has been largely implicit in strategic management books, but waged more explicitly in the various strategic management journals.47 There are numerous perspectives on strategy formulation which in many respects overlap and branch off from each other. For example, Henry
Mintzberg and Joseph Lampel identify ten different schools of strategic thought; the question is whether these are
fundamentally different ways of making strategy or different parts of the same process.48 We can identify two broad
perspectives of strategy management which at first reading may appear to be polar opposites: the rationalist or design
school and the learning school.
1.6.1 The Rationalist School
The rationalist or design school is associated with the work of Kenneth Andrews and Igor Ansoff.49 According to Andrews,
an organization needs to match its strengths and weaknesses, which derive from its resources and competences,
with the needs of its business environment. The business environment comprises both threats and opportunities. This
CHAPTER 1 What is Strategy?
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For the rationalist school, the match between these elements will lead to the creation of a number of different strategies, each of which can be evaluated and the best strategy then implemented. In the past, organizations had planning
departments which created strategies for managers to implement. The role of top management was to choose the
most appropriate strategy. However, planning is not the same as strategy. The organizations which used planning to
describe the future in great detail were disappointed to find that the future did not turn out as they expected.50 These
elaborate corporate plans were seldom consulted by managers, who continued to make the decisions they would
have made had the plan never existed.
Planning began to progress from forecasting, which produced an ephemeral best strategy, to become a basis for strategic choice. The oil company Shell developed scenario planning. Scenario planning allows managers to produce different, internally consistent views of what the future might turn out to be. This allows companies to organize their thinking
about their environment and formulate strategic alternatives. The use of models also became prevalent as companies
tried to forecast the future of the business and how it might be influenced by internal and external developments. Models
are useful for assembling and analysing data, but can only provide a background for strategic decisions. The sophisticated, econometric models simply cannot represent the real world because it is too complex to be adequately described.
A response was to develop ever more complicated mathematical models in an attempt to capture more of the complex
reality. The problem is, the model does not forecast reality in a way which users find credible, nor can they understand
the relationships described by the model. Not surprisingly, these formal approaches to analyse the environment were
not accepted by managers. Another response was to simply reject analytical models altogether and rely on intuition
and judgement. However, even a manager’s intuition will be based on an implicit model. It will be the product of previous experience in dealing with an analogous situation. The benefit of the formal model is that these assumptions are
explicit, which should help facilitate a better understanding of the issue.
The need began to develop for more qualitative ways of organizing data. Management tools, such as the product portfolio and the product life cycle, were developed. Many of these tools were developed by consultants with an emphasis
on the characteristics of industry or market. The role of competitors and competitive behaviour in influencing outcomes was not dominant; that was until Michael Porter placed competitor analysis at the heart of strategy with his five
forces framework. For the past four decades Porter, more than any other, has exemplified the rationalist approach to
strategy formulation using generic strategies.
1.6.2 The Learning School
Successful firms can pursue strategies which are opportunistic and adaptive rather than being planned. The American
political scientist, Charles Lindblom, wrote an article called ‘The science of muddling through’.51 He contrasted the
root method and the branch method of decision making. The root method requires a comprehensive evaluation of
all options based upon the objectives. The branch method involves managers building outwards, in small steps from
their current situation. For Lindblom, the root method was not useful for complex policy questions. Instead, managers
should follow the branch approach, the science of muddling through.
1
provides the familiar SWOT analysis of strengths, weaknesses, opportunities, and threats. An external analysis is used
to identify the opportunities and threats facing the firm, while an internal analysis of the organization identifies its
strengths and weaknesses.
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PART ONE What is Strategy?
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Other researchers, such as Richard Cyert and James March, argue that organizations should not be viewed as entities
with personalities and goals like individuals.52 Rather, they are more appropriately viewed as shifting coalitions, in
which conflicting demands and objectives are imperfectly reconciled. With this approach, change takes place incrementally. For Cyert and March, a rationalist approach in which senior managers determine and impose a pattern of
behaviour on the organization, fails to take account of the reality of organizational dynamics.
In contrast with the rationalist school, Mintzberg argues that a rational approach to strategy fails to take account of
how strategy making occurs in reality.53 Henry Mintzberg and James Waters suggest three approaches to strategy
formulation: intended, realized, and emergent strategies.54 (1) An intended strategy is one that the organization has
deliberately chosen to pursue and will therefore have been worked out in detail. (2) A realized strategy is the strategy
that the organization actually carries out. For a variety of reasons—for example, a change in consumer tastes—the
intended strategy may no longer be relevant for the market conditions and therefore is not implemented. Mintzberg
and Waters refer to this as an unrealized strategy. (3) In such a case, managers will have to use their experience and
learning to develop an emergent strategy which meets the needs of the changing environment. When this emergent
strategy is implemented it becomes the realized strategy. Mintzberg and Waters argue that strategy formulation is far
more likely to be a result of emergent strategies than be based on any detailed intentions. This process is shown in
Figure 1.2.
For Mintzberg, strategy is an immensely complex process, ‘which involves the most sophisticated, subtle, and, at times
subconscious elements of human thinking’. That is, strategies can develop inadvertently, quite apart from the desired
intention of senior managers. Strategy comes about as a result of a process of learning.55 However, Mintzberg does concede that all viable strategies will have emergent and deliberate qualities. This is because a viable strategy requires both
flexible learning and some degree of deliberate intention. See Strategy in Focus 1.2, which shows two competing
perspectives on Honda’s success and ultimate domination of the US motorcycle industry. The rationalist school views
Honda’s success as part of a deliberate strategy. Mintzberg, in contrast, argues that it results from an emergent strategy.
We argued at the start of this section on different perspectives that the truth often lies somewhere between competing positions and drawn battle lines. The question is not whether some approaches to strategic management are
overly rational and analytical, failing to take account of more complex processes within strategy-making. The real
question is how strategic management as a discipline moves forward and ultimately benefits the performance of
organizations, and in so doing increases society’s net benefit. With this in mind, we might reiterate that the approach
of chaos and complexity theory represents a digression from the rationalist schools of thought. Its recognition of
Intended Strategy
Deliberate Strategy
Unrealized Strategy
Realized Strategy
Emergent Strategy
Figure 1.2 Types of strategies. Source: H. Mintzberg and J. A. Waters, ‘Of strategies, deliberate and emergent’, Strategic Management Journal, vol. 6, no. 3 (1985),
pp. 257–72. © John Wiley & Sons Ltd. Reproduced with permission.
CHAPTER 1 What is Strategy?
21
STRATEGY IN FOCUS 1.2 Honda’s Dominance of the US
Honda and the Super Cub is probably the best known and most debated case in business strategy. In the 1950s,
motorcycles were sold through specialist outlets welcoming only testosterone-loaded young men. Bikes were
powerful and noisy, and the riders’ leather clothes smelt of leaking oil. Honda entered the US market in 1959
and changed everything. Five years later the company made one in two bikes sold in the US. Their best-selling
machine was the 50cc Super Cub. The company’s advertising slogan was ‘You meet the nicest people on a Honda.’
An old Honda Super Cub motorcycle. Source: © Zoi Op/Shutterstock.com
The story benefits from deconstruction. One school of explanation derives from the original Harvard Business
School case study. That case is based on a 1975 report by the Boston Consulting Group for the British
government, which described these events as the archetype of an orchestrated attack on Western markets by
1
Motorcycle Industry: Deliberate or Emergent Strategies?
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PART ONE What is Strategy?
Japanese manufacturers of consumer goods. Having established large economies of scale in the domestic
market, Honda was able to exploit its cost advantage globally.
Quite a different history was given by Richard Pascale, who went to Tokyo to interview the elderly Japanese
who had managed Honda’s first steps in the US. These executives explained that Honda had never imagined
that small bikes, popular in Japan, would find a market in the wide-open spaces of the US. They had focused on
large machines, planning to compete with US manufacturers. Mr Honda, they said, was especially confident of
success with these products because the shape of the handlebars looked like the eyebrows of Buddha.
But the eyebrows of Buddha were not appealing in the world of Marlon Brando and James Dean. The Japanese
hawked their wares around the western US, to dealers ‘who treated us discourteously and gave the impression
of being motorcycle enthusiasts who, secondarily, were in business’. The few machines they sold, ridden more
aggressively than was possible in Japan, leaked even more oil than their US counterparts.
Dispirited and short of foreign currency, the Honda executives imported some Super Cubs to ease their own
progress around the asphalt jungle of Los Angeles. Passers-by expressed interest, and eventually a Sears buyer
approached them. And the ‘nicest people’ slogan? That was invented by a University of California undergraduate
on summer assignment. Only the naive will believe either account.
Successful business strategy is a mixture of luck and judgement, opportunism and design, and even with
hindsight the relative contributions of each cannot be disentangled. Mr Honda was an irascible genius who
made inspired, intuitive decisions—with assistance from the meticulous market analysis of his colleagues and
the intense discipline of Honda’s production line operations. It is a mistake to believe that the ultimate truth
about Honda can be established through diligent research and debate. The Harvard account, although paranoid,
is right to emphasize Honda’s operational capabilities. Mr Pascale correctly stresses the human factors, but his
interviewees must have laughed as he wrote down the story of the eyebrows of Buddha.
The Boston Consulting Group naturally saw the experience curve at work and later, when peddling a
different panacea, realized it was an example of time-based competition. Gary Hamel and C. K. Prahalad
perceived the development of Honda’s ‘core competence’ in engine manufacture. Henry Mintzberg seized on
Mr Pascale’s account as an instance of emergent strategy. But there is no true story and no point in debating
what it might be.
The lesson of Honda is that a business with a distinctive capability that develops innovative products to
exploit that capability and recognizes the appropriate distribution channels for such innovations can take the
world by storm. And that lesson is valid whether Honda’s achievement was the result of careful planning or
serendipity.
Source: John Kay, ‘Driving through the spin on Honda’s big success’, Financial Times, 16 November 2004 Used under licence from the Financial Times. All
Rights Reserved.
non-linear feedback systems implies that rational approaches to decision-making may work in the short term, but
will be insufficient over the long term. There is a danger which emanates from having battle lines and positions too
clearly demarcated; common ground can often be overlooked. However, as is often the case, the truth lies somewhere
between these two perspectives. Successful strategy formulation will inevitably involve both analytical techniques
and a creative process: ‘it’s a complicated world out there. We all know we shall get nowhere without emergent learning alongside deliberate planning.’56
For a greater understanding of the debate surrounding Honda’s domination of the US motorcycle
industry, visit the online resources and see the Extension Material for this chapter.
www.oup.com/uk/henry3e/
CHAPTER 1 What is Strategy?
23
A framework is useful to help us to structure our thoughts and navigate around the different aspects of strategic management. If the purpose of strategy is to enable an organization to achieve a sustainable competitive advantage, then
any framework needs to address the process necessary for this. In Figure 1.3 we outline a framework which provides
an understanding of the organization and its environment. However, all managers need a clear sense of direction, and
this is provided by a company’s values. These values will determine the goals managers set and, therefore, the strategy
necessary to achieve them. It is in this respect that strategy can be seen as the lynchpin between the organization and
its environment.
Figure 1.3 shows the importance of values in the strategy-making process. This is shown by the arrow emanating from
values, which determine the goals the organization sets. The goals, in turn, will determine the resources and capabilities
the company requires to achieve them. Some capabilities it may already have; others it will need to acquire. Goals need
to be clearly defined, as they provide direction and motivation for individuals in the firm. The more clearly the goals are
stated and imbued within the organization, the greater the understanding by the organization’s participants of their
role in achieving these goals. An organization’s goals will reflect its strengths and weaknesses and the opportunities
and threats within its environment. Goals will also determine the types of resources the organization accumulates. The
organization will also require appropriate structures and processes in order to coordinate and implement its chosen
strategy. How the organization is structured and the processes it utilizes will again reflect the organization’s goals. An
organization’s values will also determine the relationship with its stakeholders.
Stakeholders are those individuals and groups who are impacted by the behaviour of the organization, and whose
own behaviour can, in turn, have an impact on the organization’s strategy. This is shown in the framework by arrows
which emanate from stakeholders to strategy, and strategy to stakeholders. Stakeholders reside within the organization and the environment, as shown by the linkages in the diagram. For example, managers and employees
Internal Environment
Values
External Environment
STAKEHOLDERS
General
Environment
Goals
Resources &
Capabilities
Structure &
Processes
Strengths and Weaknesses
Figure 1.3 A framework of strategic management.
STRATEGY
Competitive
Environment
Opportunities and Threats
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1.7 A Strategic Management Framework
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PART ONE What is Strategy?
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are internal stakeholders, while suppliers, shareholders, and the local community are external stakeholders. The
dichotomy between internal and external stakeholders is not always this simple, since a shareholder may also be an
employee of the firm.
Figure 1.3 links strategy and the environment, since each new strategy adopted must meet the organization’s values
and goals. Similarly, there is a link between the firm and its environment, since its values will determine the types of
markets in which it will and will not operate. This is perhaps most clearly seen in the strategies being pursued by ethical investment fund managers. The two-way arrows positioned between strategy, the organization, and the environment provide feedback on the appropriateness of the intended strategy. As we have seen, an intended strategy may
not always be implemented, often because of a change in market conditions. The arrow emanating from the macroenvironment to the competitive environment draws our attention to the fact that changes in the macro-environment
may have their greatest impact on the competitive environment. For example, the introduction of the micro-processor
in the macro-environment resulted in the destruction of the typewriter industry.
Do managers analyse their environment and then develop a strategy based on this analysis to position themselves against the environment? Or do managers develop a strategy based upon the experience and capabilities
contained within the firm and then seek to leverage this in their environment? This is an interesting question that
has provoked much debate within strategic management. On the one hand is the positioning school, which is
characterized by the work of Porter.57 This is often referred to as strategic fit or an ‘outside-in’ approach to strategic
management. On the other hand, is the resource-based view, referred to as an ‘inside-out’ approach to strategy,
which has come to be associated with Grant, Barney, Hamel, and Prahalad. This debate will be addressed in detail
in Chapters 3 and 5.
Another question we might consider is, can any of these approaches deal with a rapidly changing environment? The
work of Teece, Helfat, and Winter on dynamic capabilities, suggest neither approach can adequately deal with the
dynamic environments of the twenty-first century. We will say considerably more on this in Chapter 5.
Summary
This chapter has introduced the reader to some of the complexities that emanate from a study of strategic management. There are conflicting and competing definitions. There is disagreement over how strategy is formulated, which
gives rise to competing perspectives. This should not be seen as an insurmountable issue, since any discipline as young
as strategic management will inevitably be concerned with the exactitude of its terminology and the rigour of its
modus operandi. What we have tried to show is that, in and among all this ambiguity, there is common ground and
clarity of thought and expression. The fact that different perspectives exist at all is simply part of the dynamic nature
of strategic management.
We have identified a number of different perspectives which deal with strategy. These different perspectives will be
evaluated more fully as we assess differential firm performance in later chapters. The rationalist approach covers
strategy analysis, formulation, and implementation. However, we again reiterate that this linear approach, although
highly useful in explaining the discipline of strategy, does not fully capture how strategy occurs in reality. This is not to
demean its usefulness, since all organizations need to undertake analysis before they are ready to take decisions; it is
more to open up thinking about the different ways in which strategy formulation occurs.
CHAPTER 1 What is Strategy?
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CASE EXAMPLE Intel’s Theory of the Business
Andy Grove was born Andras Istvan Grof in Hungary, where he lived under both Nazi and later Communist
occupation. He arrived in the United States in January 1957 and shortly after changed his name to Andrew
Stephen Grove. He acquired a Ph.D. in chemical engineering at the University of California at Berkeley before
joining Fairchild Semiconductor. In 1968, Gordon Moore, along with another executive, Robert Noyce, left Fairchild Semiconductor to found Intel. When Andy Grove heard they were leaving, he decided to go with them. As
Grove recalls, ‘I never got an invitation’; he just went. At this time, there were many companies already making
chips to help companies manage their payroll and accounting. What Moore envisaged was an opportunity in a
relatively new area; Intel could put memory or data storage on microchips. These chips would allow computers
to be faster. By 1970, through innovation, hard work, and sheer determination Intel produced the industry’s first
blockbuster: a low cost memory on a chip.
The Memory Chip Market
By 1993, Andy Grove was president of Intel, a high-growth
corporation with revenues in excess of $1 billion a year. The
CEO was co-founder, Gordon Moore, who developed Moore’s
Law. This stated that the number of transistors you could
place onto a memory chip tended to double every eighteen
months. In reality, Intel had come to expect that Moore’s Law
applied only to them. In the early 1980s, there were competitors in the memory chip market, but as far as the executives
at Intel were concerned this was a market they had created. An Intel microprocessor chip, alongside the widely
recognized logo ‘Intel inside’. Source: © 4kodiak/
The market was booming and Intel was defined by memory iStockphoto
chips. Unfortunately, someone had forgotten to tell this
to their Japanese competitors. The company began to get undercut by Japanese manufacturers capable of
mass-producing high-quality, low-priced chips. Between 1978 and 1988 the market share held by Japanese
companies doubled from thirty per cent to sixty per cent.
Initially, because the company was so successful, it simply continued as before. Its success in memory
chips brought with it a belief that it could innovate itself out of the situation by developing a better chip.
This would reassert its dominance and it could again charge a premium price. In the ‘Icarus Paradox’, Danny
Miller states the very capabilities that create a company’s success can also be its downfall. Unless the executives at Intel were able to correctly diagnose the situation the company was facing and take action, Intel’s
success would be short-lived. Intel’s microprocessors were in many of the products of the new emerging
market for personal computers, but this was in its infancy. There was still a stalwart belief that memory chips
had a viable future.
Although there was some research being undertaken on microprocessors, the company’s resources and
capabilities remained primarily focused on memory chips. Most people at Intel had so much emotional capital
invested in memory chips, it was difficult to accept the reality that Japanese firms had turned their specialty into
a commodity product. The quality attributed to the Japanese memory chips was higher than Grove and others
1
Andy Grove: Intel’s First Employee
1
26
PART ONE What is Strategy?
had thought were possible. Not surprisingly, their first reaction was one of denial, before they came to the realization that they were behind. There was a great deal of debate and discussion at Intel about what to do, but no
real discussion about their core product, memory chips. Intel was desperately trying to earn a premium price for
its product. They began to think if they could earn 2X (twice) the price of Japanese memories they would be fine,
but began to realize that there was no point in this if ‘X’ got smaller and smaller. This was despite the company
losing more and more money on its memory business.
At the time, R&D was spread between different technologies. The majority was spent on memory chips. A
smaller team worked on another technology Intel had invented: microprocessors. Microprocessors are the
brains of the computer; they calculate, while memory chips merely store. However, because business had been
so good, Intel just kept on doing the same thing. As Andy Grove was to say, later, ‘we persevered because we
could afford to’. In 1985, their denial came face-to-face with reality. Profits fell from $198 million in 1984 to less
than $2 million in 1985.
Time for a Change
Months of meetings, bickering, and arguments had produced nothing but conflicting proposals. In the middle
of 1985, Grove was discussing the problem in his office with Intel Chairman and CEO, Gordon Moore. In his book,
Only the Paranoid Survive, Grove said ‘Intel equals memories in all our minds. How could we give up our identity?
How could we exist as a company that was not in the memory business? It was close to being inconceivable.’
Nonetheless, he looked out of the window at the Ferris wheel of the Great American amusement park revolving
in the distance, turned to Moore and asked this question.
‘If we got kicked out and the board brought in a new CEO, what do you think he would do?’ Without hesitating, Moore answer, ‘he would get us out of memories’. Grove stared at his CEO, numb, before suggesting, ‘Why
shouldn’t you and I walk out the door, come back and do it ourselves?’
Even though Grove was now able to say to his senior manager in charge of the memory business, ‘Get us
out of memories!’ he still allowed R&D expenditure on a product he and the manager knew they had no plans
to sell. Grove rationalized that such a major change had to take place via a number of smaller steps. However,
after a few months, he realized that this half-way decision was untenable and found the determination to
make a painful choice. They were getting out of the memory business once and for all. This meant firing
more than 7,000 people; one-third of the workforce, and closing seven factories. Grove was to take away an
important lesson from this; ‘people who do not have an emotional stake in a decision can see what needs to
be done sooner’.
Grove came to realize that when faced with difficult choices you have to make painful decisions and you can’t
hedge your commitments to them. If you do, individuals in the company will be confused and not only will
you lose direction, you will sap the energy of your organization as well. Intel faced what Grove calls a ‘strategic
inflection points’. This is a time in the life of the business when its fundamentals are about to change. They are
major changes in the way a company competes, such that simply adopting a new technology or competing in
the same old way will be insufficient. It does not have to lead to disaster, since it creates opportunities for those
who can compete in the new way. This includes both incumbents and newcomers.
While Grove and Moore made their historic decision to exit memory chips, unbeknown to them, their middle
managers were directing their manufacturing resources to the emerging microprocessor business. In performing their roles as managers, they were simply allocating resources from less profitable to more profitable lines
of production; microprocessors. The decision to exit memory chips was less drastic as a result of the actions of
Intel’s middle managers. The problem for Grove was neither a lack of strategic choice or information on which to
base decisions; his emotional commitment to memory chips was allowed to cloud his judgement and obscured
the urgent need to take a difficult decision.
When Intel decided to manufacture only microprocessors in 1985, its biggest customer and also its biggest
shareholder was IBM. It had bought shares in Intel in order to protect its supplies of microprocessors. IBM was
sixty times the size of Intel. It wanted Intel to license its 386 microprocessor designs to other manufacturers
in order for IBM to be assured of its supply of processors. This meant Intel would be relegated to the uncertain role of a parts supplier to a giant corporation. When Intel launched the 386, Grove made it clear that the
technology would not be licensed to other producers. Grove was simply not prepared to give away Intel’s
advantage to IBM.
Back to Growth
The growth of the personal computer market was to drive Intel’s massive success. If an individual had invested
$1,000 in Intel in 1985, by 2012 the investment would be worth $47,000. During the same period, the S&P 500
would have returned $7,600. During Grove’s eleven years as CEO, Intel grew at a compound annual growth rate
of nearly thirty per cent. Grove relinquished his role as CEO in 1998 and became Intel’s chairman.
In 1990, the marketing director launched a marketing campaign with the slogan ‘Intel inside’. The successful
marketing campaign turned Intel into a globally recognized brand. In 1994, a mathematician found inconsistencies in the way that Intel’s Pentium chip performed complex, scientific calculations. Intel engineers worked
out that a spreadsheet user would only encounter a problem once every 27,000 years of spreadsheet use. When
the mathematician’s findings were posted on the Internet there was a public outcry; IBM announced it was suspending sales of its Pentium chip-based computers. Grove should have recognized a strategic inflection point,
but instead could only see the issue from an engineer’s perspective and not the consumer’s. In the end, he had
to recall the product (which cost Intel $475 million) and apologize to consumers. He had failed to realize that
a brand is developed with the customer and, as such, a customer’s subjective reality becomes the company’s
objective reality. Or, to put this more simply, ‘the customer is king’.
More Change?
Grove remained as Intel’s chairman until 2005. The culture he engendered at Intel was that knowledge power
overrules position power. In other words, anyone’s ideas can be challenged as long as you are prepared to make
your point using data. His notion of ‘constructive confrontation’ meant that decisions were debated loudly
and fiercely. He relied upon what he called helpful Cassandras. These are ‘people who are quick to recognize
impending change and cry out an early warning’. Grove was to learn early on that ‘the more successful you are,
the more people want a chunk of your business and then another chunk and then another until there is nothing
left’. As CEO, Grove saw that his primary responsibility was to guard against competitor attacks and develop this
attitude throughout the organization.
By 2016, Intel CEO Brian Krzanich, had entered into a technology alliance with ARM holdings, as the company
sought to move away from the personal computer as a core computing platform, and embraced the ‘Internet
of things’; the spread of smart and connected devices. Krzanich’s view is to offer Intel’s core strength of making
chips to other chip companies working with ARM designs. This allows it to hedge against the Internet of things,
in which Intel’s own chip architecture is barely making an impression. In a major change for Intel, outright competition is giving way to collaboration.
27
1
CHAPTER 1 What is Strategy?
28
PART ONE What is Strategy?
Questions
1. How would you describe Intel’s theory of the business?
1
2. Given that Intel’s culture was one of open discussion based on data and not opinion, why did it take so
long for Gordon Moore and Andy Grove to change direction?
3. What does this case study tell you about strategy?
Sources: A. Grove, Only the paranoid survive, Profile Books, 1996; Laura Sydell, ‘Intel legends Moore and Grove: making it last’, www.npr.com, 6 April 2012;
C. Heath and D. Heath, ‘Decisive: how to make better decisions in life and work’, Random House Business, 2014; Richard S. Tedlow, ‘Fortune classic: the education
of Andy Grove’, fortune.com, 21 March 2016; Phil Rosenthal, ‘What the late Intel boss Andrew Grove can teach about managing change’, Chicago Tribune, 22
March 2016; Herminia Ibarra, ‘Andy Grove and the line between good and bad fear’, The Financial Times, 12 April 2016; Richard Waters, ‘Intel chief fights to end
dependence on the shrinking PC business’, The Financial Times, 9 September 2016.
Review Questions
1. What is strategy?
2. How does a strategic management framework aid our understanding of strategy?
Discussion Question
It is only companies which are not prepared to engage in rigorous analysis that have a vision. Discuss.
Research Topic
1. Identify organizations in which clearly communicated values correlate with organizational success.
2. Select a combination of private- and public sector organizations and identify the extent to which their
mission statement signposts to stakeholders what business they are in.
Recommended Reading
●
●
M. E. Porter, ‘What is strategy?’, Harvard Business Review, vol. 74, no. 6 (1996), pp. 61–78.
R. P. Rumelt, Good Strategy Bad Strategy, Crown Business, 2011.
For an insight into the debate on deliberate and emergent strategies, see:
●
●
●
R. T. Pascale, ‘Perspectives on strategy: the real story behind Honda’s success’, California Management Review,
vol. 26, no. 3 (1984), pp. 47–72.
H. Mintzberg, ‘The design school: reconsidering the basic premises of strategic management’, Strategic
Management Journal, vol. 11, no. 3 (1990), pp. 171–95.
H. I. Ansoff, ‘Critique of Henry Mintzberg’s “The design school: reconsidering the basic premises of strategic
management”’, Strategic Management Journal, vol. 12, no. 6 (1991), pp. 449–61.
CHAPTER 1 What is Strategy?
●
R. T. Pascale, ‘Reflections on Honda’,
California Management Review, vol. 38, no. 4 (1996), pp. 112–17.
H. Mintzberg, ‘Learning 1, Planning 0’,
California Management Review, vol. 38, no. 4 (1996), pp. 92–3.
For a comprehensive discussion of the history of strategy, see:
●
L. Freedman, Strategy, Oxford University Press, 2013.
www.oup.com/uk/henry3e/
Visit the online resources that accompany this book for activities and more information on strategy.
References and Notes
1
Carl von Clausewitz, On War, edited by A. Rapaport. Penguin, 1982.
2
D. E. Hawkins and S. Rajagopal, Sun Tzu and the Project Battleground, Palgrave Macmillan, 2005.
3
R. P. Rumelt, Good Strategy Bad Strategy, Crown Business, 2011.
4
L. Freedman, Strategy, Oxford University Press, 2013.
5
B. D. Henderson, ‘The origin of strategy’, Harvard Business Review, vol. 67, no. 6 (1989), pp. 139–43.
6
M. E. Porter, ‘What is strategy?’, Harvard Business Review, vol. 74, no. 6 (1996), pp. 61–78.
7
C. C. Markides, ‘A dynamic view of strategy’, Sloan Management Review, vol. 40, no. 3 (1999), pp. 55–63.
8
J. Kay, Foundations of Corporate Success, Oxford University Press, 1993.
9
R. P. Rumelt, Good Strategy Bad Strategy, 2nd edn, Crown Business, 2013.
10
H. Mintzberg, ‘The fall and rise of strategic planning’, Harvard Business Review, vol. 72, no. 1 (1994),
pp. 107–14.
11
K. Ohmae, The Mind of the Strategist: The Art of Japanese Business, McGraw-Hill, 1984.
12
C. C. Markides, ‘In search of strategy’, Sloan Management Review, vol. 40, no. 3 (1999), pp. 6–7.
13
Ohmae, n. 11.
14
Rumelt, n. 3.
15
For a discussion of authentic leadership see, P. Northouse, Leadership: Theory and Practice, Sage, 2016.
16
M. Lipton, ‘Demystifying the development of an organizational vision’, Sloan Management Review, vol. 37,
no. 4 (1996), pp. 83–92.
17
Rumelt, n. 3.
18
P. F. Drucker, Managing in a Time of Great Change, Butterworth Heinemann, 1995.
19
R. E. Freeman, Strategic Management: A Stakeholder Approach, Pitman, 1984, p. 46.
20
A. Campbell, M. Devine, and D. Young, A Sense of Mission, Economist Publications/Hutchinson, 1990.
21
J. C. Collins and J. I. Porras, Built to Last: Successful Habit of Visionary Companies, Harper, 1994.
22
Collins and Porras, n. 21, p. 74.
23
J. C. Collins and J. I. Porras, ‘Organizational vision and visionary organizations’, California Management
Review, vol. 34, no. 1 (1991), pp. 38.
1
●
29
1
30
PART ONE What is Strategy?
24
Collins and Porras, n. 21, p. 56.
25
Collins and Porras, n. 21.
26
Collins and Porras, n. 21, p. 97.
27
Drucker, n. 18.
28
A. S. Grove, Only the Paranoid Survive, Random House, 1996.
29
Collins and Porras, n. 21, p. 81.
30
J. Magretta, ‘Why business models matter’, Harvard Business Review, vol. 80, no. 5 (2002), pp. 86–92;
A. Ovans, ‘What is a business model?’, Harvard Business Review, January (2015), pp. 2–7.
31
S. Cliffe, ‘When your business model is in trouble: an interview with Rita Gunther McGrath’, Harvard Business
Review, vol. 89 (2011), pp. 96–8.
32
I. Ansoff, Corporate Strategy, chapter 6, McGraw-Hill, 1965.
33
M. E. Porter, Competitive Strategy: Techniques for Analysing Industries and Competitors, Free Press, 1980; M. E.
Porter, Competitive Advantage, Free Press, 1985.
34
T. J. Peters and R. H. Waterman, In Search of Excellence, Harper & Row, 1982.
35
R. M. Grant, ‘The resource-based theory of competitive advantage: implications for strategy formulation’,
California Management Review, vol. 33, Spring (1991), pp. 114–35.
36
Kay, n. 8.
37
C. K. Prahalad and G. Hamel, ‘The core competence of the organization’, Harvard Business Review, vol. 68, no.
3 (1990), pp. 79–91; G. Hamel and C. K. Prahalad, Competing for the Future, Harvard Business School Press,
1994.
38
R. Amit and P. J. H. Schoemaker, ‘Strategic assets and organisational rents’, Strategic Management Journal,
vol. 14, no. 1 (1993), pp. 33–46.
39
R. A. D’Aveni, Hypercompetition: Managing the Dynamics of Strategic Manoeuvring, Free Press, 1994.
40
Porter, n. 6.
41
Mintzberg, n. 10.
42
G. McNamara, P. M. Vaaler, and C. Devers, ‘Same as it ever was: the search for evidence of increasing
hypercompetition’, Strategic Management Journal, vol. 24, no. 3 (2003), pp. 261–78.
43
A. Brandenburger and B. J. Nalebuff, Co-opetition, Currency Doubleday, 1996.
44
D. J. Teece, G. Pisano, and A. Shuen, ‘Dynamic capabilities and strategic management’, Strategic
Management Journal, vol. 18, no. 7 (1997), pp. 509–33; D. J. Teece, ‘The foundations of enterprise
performance: dynamic and ordinary capabilities in an (economic) theory of firms’, Academy of Management,
vol. 28, no. 4 (2014), pp. 328–52.
45
S. Tallman, ‘Dynamic capabilities’ in The Oxford Handbook of Strategy, edited by A. Campbell and D. Faulkner,
Oxford University Press, 2006, 378–409.
46
R. D. Stacy and C. Mowles, Strategic Management and Organisational Dynamics, Pearson, 2016.
47
H. Mintzberg, ‘The design school: reconsidering the basic premises of strategic management’, Strategic
Management Journal, vol. 11, no 3 (1990), pp. 171–95; H. I. Ansoff, ‘Critique of Henry Mintzberg’s “The design
school: reconsidering the basic premises of strategic management”’, Strategic Management Journal, vol. 12,
no. 6 (1991), pp. 449–61.
48
H. Mintzberg and J. Lampel, ‘Reflecting on the strategy process’, Sloan Management Review, vol. 40, no. 3
(1999), pp. 21–30.
49
K. R. Andrews, The Concept of Corporate Strategy, Irwin, 1971; I. Ansoff, Corporate Strategy, chapter 6,
McGraw-Hill, 1965.
50
This section draws heavily upon J. Kay, P. McKiernan, and D. O. Faulkner, ‘The history of strategy and some
thoughts about the future’ in The Oxford Handbook of Strategy, edited by A. Campbell and D. Faulkner, Oxford
University Press, 2006, pp 27–52.
51
J. Kay, ‘History vindicates the science of muddling through’, The Financial Times, 14 April 2009.
52
Kay et al., n. 50.
53
Mintzberg, n. 47.
54
H. Mintzberg and J. A. Waters, ‘Of strategies, deliberate and emergent’, Strategic Management Journal, vol. 6,
no. 3 (1985), pp. 257–72.
55
Mintzberg, n. 10.
56
H. Mintzberg, ‘Learning 1, Planning 0’, California Management Review, vol. 38, no. 4 (1996), pp. 92–3.
57
Henderson, n. 5.
31
1
CHAPTER 1 What is Strategy?
PART TWO
STRATEGIC
ANALYSIS
2 Evaluating the Macro-environment
33
3 Industry Analysis
57
4 The Internal Environment: Value-creating Activities
85
5 The Internal Environment: A Resource-based
View of Strategy
114
CHAPTER 2
EVALUATING THE
MACRO-ENVIRONMENT
2.1 The Macroenvironment
2.2 Scanning, Monitoring,
and Forecasting Changes
in the Environment
Extension Material
Strategic decision
making under conditions
of uncertainty
2.3 Scenario
Planning
2.4
PEST Analysis
Extension Material
Strategic inflection
points and their
impact on strategy
Working through
Strategy
Undertaking scenario
planning
2.5 An
Introduction
to SWOT Analysis
2.6 The
Macro-environment
and Industry Analysis
Working through
Strategy
Writing a PEST
analysis
Main Reference
Schoemaker, P.J.H. (1995).
Scenario planning: a tool
for strategic thinking. Sloan
Management Review, 36(2), 25.
Learning Objectives
After completing this chapter you should be able to:
●
●
●
●
●
●
Define what constitutes the macro-environment
Evaluate the role of scanning and monitoring in detecting environmental trends
Apply scenario planning to decision making in uncertain environments
Evaluate PEST as a framework for analysing the macro-environment
Explain the use of SWOT analysis
Evaluate the relationship between the macro-environment and the competitive environment
36
PART TWO Strategic Analysis
2
Introduction
What happens in the macro-environment is important to an organization. This is because changes that take place in
the macro-environment may point to trends that can substantially impact upon an organization’s competitive environment. These changes, which are often referred to as disruptions, discontinuities, or tipping points, fundamentally
impact on the firm’s competitive environment and are considered in this chapter. The tools of analysis an organization
can use to discern changes in its macro-environment are also considered. This includes scenario planning, which is
assessed as an aid to organizational decision making under conditions of uncertainty. The benefits and limitations of
a PEST framework, which includes political, economic, social, and technological factors, is addressed. A SWOT analysis
and its links with scenario planning and PEST analysis is briefly discussed, before being taken up in detail in Chapter 4.
The aim of this chapter is not merely to apply these techniques but, importantly, to understand their limitations. The
chapter ends with a discussion of the links between the macro-environment and competitive environment.
2.1 The Macro-environment
The external environment facing the organization consists of both a macro-environment and a competitive environment. The competitive environment consists of the industry and markets in which organizations compete. The
competitive environment is analysed in detail in Chapter 3. The macro-environment, in contrast, is often referred to as
the general environment. This is because changes that occur here will have an effect that transcends firms and specific
industries. Figure 2.1 shows the relationship between the macro-environment, the competitive environment, and the
The General Environment
Political
Economic
The Competitive Environment
Potential Entrants
Power of
Buyers
The
Organization
Power of
Suppliers
Competitive
Rivalry
Substitute
Products/Services
Social
Figure 2.1 The organization and its external environment.
Technological
CHAPTER 2 Evaluating the Macro-Environment
37
That said, organizations must continually scan and monitor their macro-environment for signals, often weak or barely
perceptible, which might indicate a change in their competitive environment. For example, firms in the industry that
produced typewriters would have been unwise not to scan the macro-environment for signs of change, in this case
technological change. The advent of micro-technologies was a clear threat to the typewriter industry, ushering in as
it did the era of word processors, personal computers, and the now ubiquitous portable, digital devices. It is easy to
forget that individuals who relied upon the use of the typewriter were initially sceptical about learning how to use the
new technology. That said, the use of the QWERTY keyboard that was used with typewriters, despite not being the best
design,1 continues to proliferate with smartphones and tablets.
In order to scan and monitor their environment, organizations require tools of analysis or models that will allow them
to factor in the changes in the macro-environment and evaluate their impact. One such approach involves scanning
the environment to detect signals that will act as a signpost for future changes in the organization’s industry. In addition, an organization must monitor its environment to discern patterns and trends that are beginning to form and try to
forecast the future direction of these trends. Peter Ginter and Jack Duncan2 argue that macro-environmental analysis
can act as an early-warning system by giving organizations time to anticipate opportunities and threats and develop
appropriate responses.
Therefore, the aim of macro-environmental analysis is to aid the organization in discerning trends in the macro-environment which might impact upon its industry and markets. The organization is then able to formulate a strategy and
use its internal resources and capabilities to position itself to exploit opportunities as they arise. At the same time, the
strategy will be acting to mitigate the effects of any threats. However, as we shall see in Chapter 3, there are proponents for and against the view that the pace of innovation and disruption in the competitive environment is increasing
over time. If the rate of change is increasing, this uncertainty effectively shortens the lead time an organization has to
anticipate and respond to changes in its competitive environment.
2.2 Scanning, Monitoring, and Forecasting
Changes in the Environment
The purpose of scanning and monitoring the macro-environment is to try to discern changes, however small, that
have the potential to disrupt an organization’s competitive environment. Once these changes are discerned, it is up
to the organization to monitor them and see if they might become a trend that can affect its industry. Clearly, experience and intuition will be involved in trying to forecast where these changes will eventually manifest themselves,
or indeed if they will have any impact at all. In reality, the problem with trying to predict changes in any environment is that there are known knowns, known unknowns, and unknown unknowns.3 In other words, there are things
that we know that we know, there are things that we know we don’t know, and there are things we don’t even know
that we don’t know. We look at scanning, monitoring, and forecasting changes in the macro-environment below
with this caveat in mind.
2
organization. It should be noted that, other things being equal, it is changes in the competitive environment that have
the most direct and immediate impact on the organization.
38
PART TWO Strategic Analysis
2
2.2.1 Scanning the Environment
It is often said that there are two certainties in life: death and taxes. However, a third certainty can be added: change.
If the external environment facing organizations was stable and simple to understand, then firms would be faced
with an enviable situation of having relatively little change or, if change occured, it would be easy to forecast based
on historic trends. Some commodity markets exhibit a relative degree of stability, making predictions or extrapolations based on past data quite reliable. However, most environmental conditions facing organizations are complex,
uncertain, and prone to change. They are complex because of the sheer volume of data that exists in the environment.
Therefore, any analytical tool or framework can only extract and simplify a tiny proportion of this data. At the same
time, any given source of data, for example economic data on the well-being of the economy, is ambiguous, as it can
be interpreted in a number of different ways.
If past performance is no guarantee of what will occur in the future because of uneven changes and disruptive innovation, then attempts at forecasting the future are fraught with uncertainty. Disruptive innovation refers to a process in
which a smaller company with fewer resources manages to successfully challenge established incumbent businesses.4
It was popularized by Harvard professor, Clayton Christensen, who differentiated between what he called sustaining
and disruptive innovations.5 A sustaining innovation allows an organization to enhance the performance of its existing
technology. This sustaining innovation is usually adopted by incumbent firms in the industry which will have invested
substantial financial and emotional capital in their current technology.
In contrast, a disruptive technology creates a new performance trajectory for consumers based on different attributes
than those of the existing technology used by the incumbent firm. Throughout history these discontinuities have
ash buttons are an example of Amazon innovating how customers can purchase products at the touch of a button. Source: © James W. Copeland/
D
Shutterstock.com
CHAPTER 2 Evaluating the Macro-Environment
39
Fahey and Narayanan suggest three goals for an analysis of the macro-environment.6 First, the analysis should provide an understanding of current and potential changes taking place in the environment. Second, it should provide
important intelligence for strategic decision makers. Third, environmental analysis should facilitate and foster strategic thinking in organizations. For Fahey and Narayanan, scanning may reveal ‘actual or imminent environmental
change because it explicitly focuses on areas that the organization may have previously neglected’.7 Scanning the
environment as a general activity has been made far more cost-effective with the advent of the Internet. Prior to the
Internet, the view was that scanning was a costly activity, which could only take account of a fraction of the information that existed in an organization’s environment. By redefining search costs, the Internet has changed the economics
of undertaking scanning. At the same time, it has provided an opportunity to access a wealth of data which requires
time and effort to structure properly.
Scanning, therefore, is an opportunity for the organization to detect weak signals in the macro-environment before
these have coalesced into a discernible pattern which might affect its competitive environment. Weak signals refer to
minor changes in the external environment that an organization’s scanning of the environment may barely register.
This is because their impact has yet to be felt. The key for organizations is to be able to read these signals correctly
and monitor them until they coalesce into a more clearly discernible pattern. However, there are errors that can follow when looking for patterns. The first is that the organization may fail to identify these signals. The second is that
the organization may discern a pattern that is not there, but is based on the assumptions and mental models that
managers carry in their heads.
This is referred to as cognitive bias. Cognitive bias takes place as we think about different courses of action. It leads
managers to rely heavily upon their own intuition and judgements which are based on past experiences. In effect,
managers assign too much or not enough significance to information which in turn causes them to make inappropriate decisions.8 This is because we view our experience through filters which have the effect of distorting reality.
As a result, our experience betrays us, instead of making us wiser, because it introduces systematic errors into our
decision-making process.9 As the Russian novelist, Leo Tolstoy said, ‘everyone thinks of changing the world, but no one
thinks of changing himself’.
We saw in Chapter 1 how a manager’s reliance on its existing theory of the business can affect the success of the
organization by blindsiding him or her to changes taking place in the environment. Ansoff 10 makes the point that the
detection of weak signals requires senior management commitment and sensitivity on the part of the observers. This
means that the organization must be diligent in continually scanning its macro-environment for weak signals. When it
believes that it has discerned something significant occurring in its macro-environment, this broad scanning can turn
into a more focused monitoring. Of course, managers must first be aware of and then deal with their cognitive bias if
the weak signal is not to be misinterpreted.
2
often manifested themselves in disruptive technologies, from the replacement of the horse and carriage by motorcars to IBM mainframes being disrupted by the PC revolution. The key to exploiting disruptive technologies is first
to recognize their existence, irrespective of the capital already invested in the current technologies. Next, to make
a corporate wide decision to embrace the disruptive technology, being prepared to change the business model on
which your organization is based. We will say much more about disruptive innovation in Chapters 3 and 7. Examples
of disruptive innovators include Amazon and Netflix, which have both taken advantage of the Internet to change the
way established products are customized and delivered to end consumers.
40
PART TWO Strategic Analysis
2
2.2.2 Monitoring the Environment
While scanning the environment may make organizations aware of weak signals, unless these are carefully monitored
the resulting patterns will be missed. Monitoring can be seen as the activity that follows these initially disparate signals
and tracks them as they grow into more clearly discernible patterns. Monitoring allows an organization to see how
these macro-environment trends will impact on its competitive environment. Whereas scanning is a more broad-brush
approach, monitoring uses a finer brush stroke. However, the two are inseparable, since without an identification of
weak signals in the macro-environment there is no focus for an organization’s monitoring activities. One way in which an
organization might monitor weak signals is to set thresholds such that any activity which occurs above the threshold will
be monitored. This might include, for example, when an interest is shown by a major competitor in a particular social or
technological change. This interest then becomes the threshold at which the organization itself starts to take an interest.
2.2.3 Forecasting Changes in the Environment
The purpose of scanning and monitoring the macro-environment is to aid the organization in developing viable forecasts of future trends before they become an unmitigated threat. This is particularly useful when dealing with disruptions which themselves will usually evolve from weak signals that exist in the environment. The objective is to use this
information to develop robust strategies that ensure a degree of competitive advantage. To accomplish this requires
some understanding of the nature of uncertainty.
Kees van der Heijden,11 a former head of scenario planning at Shell, identifies three main types of uncertainty.
1. Risks. This is where past performance of similar events allows us to estimate the probabilities of future outcomes.
2. Structural uncertainties. This is where an event is unique enough not to offer evidence of such probabilities.
3. Unknowables. This is where we cannot even imagine the event.
Most managers are capable of dealing with the type of uncertainty that appears in the form of risks. Also, what
is unknowable cannot, by definition, be forecast and therefore the organization must wait for the event to occur
before it can react to it. This leaves structural uncertainties where no probable pattern of outcomes can be
derived from previous experience. In such a situation, van der Heijden suggests scenario planning as a useful tool
of analysis to help the organization make sense of an uncertain and dynamic environment that has little in the way
of clear road maps.
For information on strategic decision making under conditions of uncertainty, go to the online
resources and see the Extension Material for this chapter.
www.oup.com/uk/henry3e/
2.3 Scenario Planning
Paul Schoemaker12 states that ‘scenario planning is a disciplined method for imagining possible futures’. For Michael
Porter, scenario planning is ‘an internally consistent view of what the future might turn out to be’.13 The oil multinational
Royal Dutch Shell has used scenario planning since the 1970s to help it generate and evaluate its strategic options.
CHAPTER 2 Evaluating the Macro-Environment
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Scenario planning has given Shell a better success rate in its oil forecasts than its competitors, and it was the first oil
company to see overcapacity in the tanker business and Europe’s petrochemicals.14 As Adam Kahane reminds us:
These stories promote a discussion of possibilities beyond the most likely one and encourage the organization to
consider ‘what if’ questions. Therefore, a scenario can be seen as a challenging, plausible, and internally consistent
view of what the future might turn out to be. It is not a forecast in the sense that one is able to extrapolate using past
data. However, it does deal with the future and provides a tool of analysis for the organization to structure the surfeit
of information that is contained in the present. In particular, scenarios help organizations recognize the weak signals
that signpost changes in its macro-environment. It is these weak signals which precede environmental discontinuities
and disruptions, or what former CEO of Intel, Andy Grove, refers to as strategic inflection points, that help shape the
competitive environment.16 If an organization is to remain proactive in its competitive environment it must not allow
the rules of the game to be changed to its detriment; that is, it must be capable of dealing with a tipping point. A phrase
popularized by journalist, Malcolm Gladwell, a tipping point refers to a moment in time when consumer demand for a
product crosses a threshold and tips, causing demand to increase exponentially.17
For a discussion of strategic inflection points and their impact on strategy, visit the online resources
and see the Extension Material for this chapter.
www.oup.com/uk/henry3e/
Strategic decisions are almost always fraught with ambiguity and uncertainty, which create complexity for decision
makers. We have described above how as as human beings we are subject to biases and imperfect reasoning about
uncertainty. That is, as individuals we will tend to misread events that are unlikely, and either ignore or overemphasize
unlikely but significant events. In an attempt to resolve these shortcomings, most companies will use some form of
discounted cash flow coupled with sensitivity analysis when analysing risky strategic decisions. The problem with
these quantitative approaches is that they imbue the decision making with a false sense of objectivity and can be
misleading. For example, sensitivity analysis is seen as overly simplistic in that by varying one parameter at a time it
fails to incorporate any links or correlations between them. Scenario planning is an approach to decision making under
conditions of uncertainty that helps to overcome many of the shortcomings of traditional decision-making methods;
that is, scenario planning allows organizations to change several variables at the same time without keeping other
variables constant. Crucially, scenario planning helps to overcome some of the biases and imperfect reasoning that
human beings make under conditions of uncertainty.18
Scenarios are a tool of analysis to help improve the decision-making process set against the background of a number
of possible future environments. They benefit the organization by readily helping managers think in a more systematic
way. This allows individuals to more readily recognize change in their business environment instead of ignoring or
rejecting it. van der Heijden outlines the benefits of scenario planning for Shell:
●
More robust strategic decisions
●
Better thinking about the future by a ‘stretching mental model’
2
In the oil industry, experts have sometimes been able to suggest, but rarely to predict, the key turning points in
crude oil prices . . . . The Shell approach to strategic planning is, instead of forecasts, to use scenarios, a set of stories
about alternative futures.15
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●
Enhancing corporate perception and recognizing events as a pattern (the recognition and monitoring of weak
signals until they coalesce into a pattern is relevant here)
●
Improving communication throughout the company by providing a context for decisions
●
A means to provide leadership to the organization.
The process of scenario planning should have the objective of positively influencing the strategy of the organization. This requires that the scenarios devised should stretch the imagination of management while also remaining
plausible. In order to achieve this, organizations must be prepared to invest resources in educating managers to help
them make the best use of scenarios. They need to recognize that developing scenarios takes time and is most effective when managers from different parts of the business interact. By constructing multiple scenarios, an organization
can explore the consequences of uncertainty for its choice of strategies. Furthermore, an organization can formulate
strategies knowing that the assumptions on which it competes, Drucker’s theory of the business, are surfaced and
adequately assessed.
2.3.1 How to Build Scenarios
Scenario planning is relevant to almost any situation in which a decision maker needs to understand how the future of
his or her industry or strategic business unit might develop.19 It divides our knowledge into two areas: (1) things we
think we know something about; and (2) things we consider uncertain or unknowable. The first area is based on the
past and continuity. For example, an organization can make fairly safe assumptions about the direction of a country’s
demographic profile. The uncertain elements include such things as future oil prices, interest rates, and the outcomes
of political elections. Even here it is not necessary to account for every possible outcome, since simplifying the outcome
is fine for scenario planning. Therefore, an organization might simply categorize future interest rates as high, medium,
or low, rather than trying to work out every possible permutation. Also, as scenarios highlight possible futures but not
specific strategy formulations, outside opinions such as those of consultants can be included in the process.
A process for building scenarios is:
1. Define the scope. This involves setting the time frame and the scope of analysis. The time frame can be determined by factors such as product life cycles and rate of technological change. The scope of analysis may include
products, markets, and geographical areas. Once the time frame is set, the question becomes: what knowledge
would the organization benefit most from in that timescale?
2. Identify the major stakeholders. Stakeholders are individuals and groups who can affect and are affected by
the organization’s decisions. The organization needs to know their current levels of interests and power, and how
these have changed over time.
3. Identify basic trends. Which political, economic, social, technological, and industry factors will have the most
impact on the issues identified in Step 1? The impact of these trends on current strategy can be listed as positive,
negative, or uncertain.
4. Identify key uncertainties. Which events that have an uncertain outcome will most affect the issues the
organization is concerned with? Here again the organization might consider political, economic, social, and
technological factors, in addition to industry factors. For example, what trends in consumer behaviour are
likely to characterize future consumer demand? These key uncertainties should be limited to keep the analysis simple.
CHAPTER 2 Evaluating the Macro-Environment
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6. Check for consistency and plausibility. This involves checking to see if the trends identified are compatible with the chosen time frame. If they are not, then remove all the trends that do not fit the time frame.
Do the scenarios combine outcomes of uncertainty that actually go together? In other words, ensure
that inconsistent outcomes are not put in a scenario, such as having full employment and zero inflation together. Finally, have major stakeholders been placed in a position they will not tolerate or cannot
change? In this case, the scenario described will probably change into another one. The key then is to
identify this ultimate scenario.
7. Develop learning scenarios. Here the role is to develop relevant themes for the organization around which
possible outcomes and trends can be organized. The scenarios can be given a name or title to reflect that they
tell a story. This also helps individuals to remember the scenarios. At this stage, the scenarios are useful for
research and further learning within the organization rather than decision making.
8. Identify research needs. Further research may be required to understand uncertainties and trends more fully.
This is because organizations are knowledgeable about their own competitive environment, but less knowledgeable about other industries. Therefore, the organization may need to study changes, in disruptive technology for instance, which have yet to impact its industry, but may ultimately do so.
9. Develop quantitative models. Once further research has been gained, the organization may wish to revisit the
internal consistency of the scenarios and decide whether it might benefit from formalizing some interactions in
a quantitative model.
10. Evolve towards decision scenarios. The ultimate aim of the scenario building process is to move the organization towards scenarios that can be used to test its strategy formulation and help it generate new ideas. At
this point it is helpful to double check Steps 1–8 to see if the scenarios take account of the issues facing the
organization.
If the scenarios are useful to the organization, they might have the following characteristics: (1) they address the
concerns of individuals in the organization; (2) the scenarios are internally consistent; (3) they describe fundamentally
different futures as opposed to being variations on a particular theme; and (4) each scenario describes an equilibrium
state that can exist for a considerable period of time as opposed to being merely short-lived. In summary, Schoemaker
states:
scenario planning attempts to capture the richness and range of possibilities, stimulating decision makers to
consider changes they would otherwise ignore . . . organizing . . . into narratives that are easier to grasp and use
than great volumes of data. Above all . . . scenarios are aimed at challenging the prevailing mind-set.20
It is worth reiterating that scenarios are not intended to predict the future. They are designed to help managers deal
with a highly uncertain and dynamic environment. They may be utilized at the macro or competitive environment.
Porter, whilst recognizing the value of multiple scenarios for an organization’s choice of strategy, when considering scenario planning at the macro-environment level, argues that ‘Macro scenarios, despite their relevance, are too
general to be sufficient for developing strategy in a particular industry.’21 Whether this statement is accepted may
depend more on the industry being addressed rather than scenario planning per se.
2
5. Construct initial scenario themes. Once trends and uncertainties are developed, the organization has the basic
building blocks for scenario planning. It can then identify disruptive changes in market conditions by congregating all positive elements in one scenario and negative elements in another broad scenario.
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Scenarios encourage management to ‘think the unthinkable’, to question and surface assumptions they hold about
the environment, and to be prepared to view events from a radically different perspective. Scenarios are a tool of
analysis that examines the impact of uncertainty on organizations and industries by explicitly identifying some of the
key uncertainties—the scenario variables. For scenarios to be effective, they must encourage the creation of robust
strategies that match the organization’s limited resources with the endless challenges in the external environment. To
do this, scenario planning must ensure that as many as possible of the long-term opportunities and threats facing the
organization are identified and addressed.
For more information on how to undertake scenario planning, go to the online resources and see
the Working through Strategy feature for this chapter.
www.oup.com/uk/henry3e/
2.4 PEST Analysis
A useful tool when scanning the macro-environment is PEST analysis. This refers to political, economic, social, and
technological factors. It is worth noting that some commentators include legal and environmental factors separately,
preferring to extend the acronym to PESTLE. However, the legal element of the acronym can be subsumed within the
political factor. In addition, the use of the last E (which refers to environmental factors) is often meant to signify the
effects of our lifestyles on our environment, such as the use of fossil fuels and their impact upon climate change. In this
respect, it can be captured within the ‘social’ factor, or indeed within all four factors in one form or another. Therefore,
it is not important whether we use PEST (or STEP) or PESTLE, but rather to understand how this framework can be used
and to be aware of its limitations. As long as the choice of acronym is clearly defined we have a consistent approach.
How will PEST analysis aid the organization? PEST analysis is simply another tool to help the organization detect and
monitor those weak signals in the hope of recognizing changes taking place in the macro-environment. PEST analysis
can be used to help detect trends in the macro-environment that will ultimately find their way into the industry in
which the firm competes. It provides a link between the macro-environment and industries in that weak signals in the
macro-environment can become key forces for change in industry conditions. Although we will deal with each factor
in turn, it should be noted that interrelationships between the factors exist.
2.4.1 Political Factors
The political factor of PEST deals with the effects of government policy. In as much as government policy is worked out
through legislation, it encompasses all legal elements of this analysis. This includes items such as government stability, taxation policy, and government regulation. Government stability is seldom a major issue in Western economies.
However, where multinational corporations operate across international borders, political factors to take into account
include: the stability of governments and political systems in those countries. Whether there will be any sudden and
detrimental legislative changes that might jeopardize the substantial investments they will have made. The effects
of a change in government policy on the safety of their personnel operating in these countries. And, the effect of a
change in policy on the organization’s infrastructure which allows the efficient transfer of goods and services as well
as financial assets.
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In the UK, there is a growing concern around the increase in rates of obesity, particularly among children, and the
effect this has on individual health and life expectancy. Celebrity chef, Jamie Oliver, the NHS, and health charities have
been vocal proponents for a tax on sugar-sweetened drinks. As a result, the British government introduced a ‘sugar tax’
on soft drinks with excess levels of added sugar. Manufacturers will be taxed according to the quantity of the sugarsweetened drinks they produce or import.22 The weak signals were already beginning to coalesce into a pattern of
possible legislation for drink manufacturers scanning the macro-environment.
Porter and van der Linde23 suggest that environmental regulations, such as reducing pollution, may act to spur competitive companies on to innovate and reduce costs to counter the increased costs of regulation. While the US car
makers fought new fuel consumption standards in the vain hope that they would go away, the Japanese and German
car makers developed lighter and more fuel-efficient cars. The companies that reap the competitive benefits will be
the early movers: ‘the companies that see the opportunity first and embrace innovation-based solutions’. To do this,
managers need to develop a new mind set which recognizes environmental improvement as a competitive opportunity rather than as a threat.
2.4.2 Economic Factors
The changes in economic activity manifest themselves through changes in interest rates, disposable income, unemployment rates, retail price index (inflation), gross domestic product (GDP), and exchange rates. However, economic
data can be notoriously fickle and ambiguous. In addition, an economic indicator can never provide a complete picture
(even of the subset of data it purports to track), but rather provides a snapshot and simplification of complex economic
phenomena. This makes scanning and monitoring the macro-environment for signs of economic shifts very difficult.
Do you know how much sugar is in your drink? Source: © Marcos Mesa Sam Wordley/Shutterstock
2
A change in government policy in favour of deregulation or privatization has the effect of opening up markets to
competition. Organizations within the industry are forced to innovate and achieve efficiencies to remain competitive. This is because new entrants will often enter a market with lower cost curves and more innovative products and
services owing to a better use of technology and a clearer understanding of consumer needs. Firms, therefore, need
to be scanning their macro-environment for signs of change in government policy which may impact their industry.
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The strengthening of an economy will generally benefit industries, but the extent of its effect will vary according to
which economic factors are most affected. For example, the construction industry and manufacturing are most susceptible to increases in the rate of interest. Manufacturing organizations which export goods abroad will be scanning
the macro-environment for signs of an appreciation in exchange rates, the effect of which will be to make it harder
for them to sell their goods abroad, but relatively easier for competing importers to sell their goods in the domestic
market. See Strategy in Focus 2.1.
STRATEGY IN FOCUS 2.1 Delays with Building Construction
T he construction industry is most susceptible to increases in the rate of interest.
Source: © Salvador Aznar/Shutterstock.com
The Aberdeen Western Peripheral Route was billed as a ‘major infrastructure project that will significantly
improve travel in north east Scotland’. But, for Carillion at least, it has turned out to be a major headache that
significantly hurt its finances. The troubled firm was part of the consortium—with partners Balfour Beatty and
Galliford Try—that was awarded the contract to build the road in December 2014.
At the time, the decision was widely welcomed by both the Scottish Government and the local council.
There had been a long wait for the 36-mile (58-km) route and the project was expected to provide thousands
of jobs for local people, many of whom had suffered as the oil industry slowed. However, at some point the
scheme went wildly off course. Indeed, the road in Aberdeen typifies Carillion’s problems: a project that should
have been relatively simple has been dogged by delays, pushing costs up and leaving the firm with a serious
cash-flow problem.
At the heart of the matter lies a problem of procurement: why do contractors often get the prices and
timescales on major projects so wrong? It all comes down to risk, and who is willing to take it, explains the
chairman of a construction consultancy. ‘Naturally the client wants to minimise their exposure to risk’, he says.
‘Contractors are the risk takers, which is where they can make their profits, but it can backfire.’ Companies are
forced to bid for five or ten-year projects at a fixed cost, particularly when the client is a public sector body, he
says. ‘What’s been happening is that contractors have been pitching for jobs and they’ll put a price in. Then they
start talking to subcontractors, and then the subcontractors come back with prices that are more expensive.’
He says it is notoriously difficult to predict what the labour market or the cost of materials, such as steel, will
be over the life of a project, meaning that a fixed cost at the start of a contract might seem wildly ambitious by
the end. This all chips away at wafer-thin margins, which could be only two per cent to start with. Others have
suggested that the problem for Carillion lies in the subcontractors themselves. Over the years, companies have
cut back on what is carried out in-house, meaning they have less control over the work being done. In Aberdeen,
Carillion, Balfour Beatty, and Galliford Try tendered for subcontractors to do work including drainage, plant and
equipment hire, earthworks, steel reinforcement, and rock crushing, through contracts worth almost £200m.
The new road route had been on the cards for nine years before it was finally approved by ministers in 2012;
by then, the cost of the scheme had swelled from an initial government estimate of between £295m and £395m,
to £745m. Construction finally got under way in February 2015, with the road due to open in 2017. But it became
clear the target was not going to be met. At the time, the Scottish transport minister told a worried public that
the cost of the delays would be borne by the contractors, not by taxpayers.
Every time work is pushed back or they run into a problem, companies have to shell out more money for extra
labour costs, extra materials, machine hire, and a host of other costs. What is more, once they are in trouble, many
companies do not own many assets, and so have difficulty raising money to bail themselves out. What is clear is
that there is a pinch point between the needs of the client and the contractor, which comes down to having to
offer work at a competitive rate, while also making sure that the work can be carried out for the right cost.
Source: Rhiannon Bury, ‘Carillion’s risky road shows the short, sharp shocks of building for the long term’, The Telegraph, 25 July 2017. © Telegraph Media Group
Limited Reproduced with permission.
Since the financial crisis in 2008, there have been many political and economic signals aimed at the financial services
industry. For example, the bailout of US and European banks by the taxpayer led to government proposals to ensure
that banks were not undercapitalized. Further regulation has been proposed to safeguard the consumer. Also proposals that banks separate their investment activities from their retail activities.
2.4.3 Social Factors
Social factors include changes in demographics and culture. In many Western economies, there exists a trend towards
an ageing population. Retail organizations in Europe and the US have responded to this changing demographic by
employing older personnel. They recognize that retired employees often possess a wealth of experience that can add
value when serving customers. At the same time, Western governments are having to fund an increasing pension pot
with fewer workers. In the UK, consumer concern with genetically modified food (GMF) forced the government to
scale down its introduction of genetically modified crops. The frozen food retailer Iceland was the first retailer to state
that none of its food products contain genetically modified ingredients. Iceland had accurately read a change in social
trends which influenced consumer spending patterns; other supermarkets were quick to follow.
In response to a falling birth rate, companies like Johnson & Johnson, involved with the provision of baby-care products,
have effectively targeted these products at an adult female audience. For example, their baby lotion is now also marketed
as being kind and gentle to women’s skin. This is a response to changes in the macro-environment that affect their industry.
2.4.4 Technological Factors
Some of the major disruptions taking place in the macro-environment are technological. Think about how Amazon
and Dell have used the Internet to challenge traditional retailing. Technological factors include rates of obsolescence;
that is, the speed with which new technological discoveries supercede established technologies. The rate of change in
technology and innovation has the effect of causing new industries to emerge and changes the ways in which existing
industries compete.
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The rapid rate of change of technology has changed the dynamics in industries such as newspaper publishing,
banking, financial services, and insurance. This has allowed new entrants to enter the market at a lower cost base
than incumbents, offering more competitively priced products and services and gaining market share in the process. For example, Blockbuster mail order business model was no match for Netflix’s use of digital technology to
stream films online ‘on demand’ and via ‘subscription’ (see Case Example: Disruptive Innovation from Netflix at
the end of the chapter).
The Internet has been compared to the Industrial Revolution in terms of the technological innovations it has brought
about. If the rate of change of technology is indeed increasing, this makes it important to try to detect weak signals
which will change how industries compete. Organizations may not be able to predict these events, but using PEST
and scenario planning they may be in a stronger competitive position to respond to them once they have occurred.
One could be forgiven for thinking that a major factor in the push for electric cars is the new technology. However,
electric cars are about more than technology. There are social implications, for instance, consumer concerns about
the effect on the environment of cars which emit carbon dioxide. There are political concerns, for example, car manufacturers face stringent carbon dioxide emissions tests, which increase their costs. Traditional motor manufacturers need to be aware of these macro-changes, which will impact their industry, and can also make use of scenario
planning to deal with the uncertainty. Given that more electric cars are sold in China than in the rest of the world
combined, albeit with generous government subsidies, this presents an opportunity for Western manufacturers. See
Strategy in Focus 2.2.
STRATEGY IN FOCUS 2.2 Are Electric Cars the Future?
E lectric cars are becoming an increasingly common sight on our streets. Source: ©
Scharfsinn/Shutterstock.com
THE high-pitched whirr of an electric car may not stir the soul like the bellow and growl of an internal combustion
engine (ICE). But to compensate, electric motors give even the humblest cars explosive acceleration. Electric
cars are similarly set for rapid forward thrust. Improving technology and tightening regulations on emissions
from ICEs is about to propel electric vehicles (EVs) from a niche to the mainstream. After more than a century
of reliance on fossil fuels, however, the route from petrol power to volts will be a tough one for car makers to
navigate.
The change of gear is recent. One car in a hundred sold today is powered by electricity. The proportion of
EVs on the world’s roads is still well below one per cent. Most forecasters had reckoned that by 2025 that would
rise to around four per cent. Those estimates are undergoing a big overhaul as car makers announce huge
expansions in their production of EVs. Morgan Stanley, a bank, now says that by 2025 EV sales will hit £7 million
a year and make up seven per cent of vehicles on the road. But as car makers plan for ever more battery power,
even these figures could quickly seem too low.
Ford’s boss is bolder still. Mark Fields announced that the ‘era of the electric vehicle is dawning’, and he reckons
that the number of models of EVs will exceed pure ICE-powered cars within fifteen years. Ford has promised
thirteen new electrified cars over the next five years. Others are making bigger commitments. Volkswagen,
the world’s biggest car maker, said last year that it would begin a product blitz in 2020 and launch thirty new
battery-powered models by 2025, when EVs will account for up to one-quarter of its sales. Daimler, a German
rival, also recently set an ambitious target of up to one-fifth of sales by the same date.
The surge has two explanations: the rising cost of complying with emissions regulations, and the falling cost
of batteries. Pure EVs, which send no carbon dioxide directly into the atmosphere, and hybrids, which produce
far less than conventional engines, are a way to meet Europe’s emissions targets—albeit an expensive one. But
the gains from cheaper methods such as turbocharging smaller engines, stop–start technology, and weight
reductions will no longer be enough, since a tougher testing regime, to be introduced in the wake of VW’s
diesel-cheating scandal, will make those targets still harder to reach. The hefty cost of preventing nitrogen
oxide spewing from diesel engines, which emit far less carbon dioxide than the petrol equivalent, may see them
disappear by 2025. Further development of ICEs could be enough to meet the 2021 targets. Car makers also
need to be prepared to hit the next targets. These, yet to be finalized in the EU for carbon dioxide, may be as low
as 68g/km by 2025, compared with 130g/km today.
Regulations are favourable outside Europe, too. In China, more than 400,000 pure EVs were sold last year,
making it the world’s biggest market. The government, keen to clear the air of choking exhaust fumes, has plans
for a quota that could insist that eight per cent of sales are EVs or hybrids by 2018. And even if the US president
relaxes US emissions standards, this will not hold back electrification. California, which accounts for one in eight
cars sold in the US, is allowed to set tougher environmental standards than the national ones. It, and seven of the
other states that have adopted its emissions rules, have a target of 3.3m EVs on their roads by 2025.
Technology will have as much impact as politics. Vehicles that car makers are forced to produce for the sake
of the environment will become ones that buyers want for the sake of their wallets. EVs were once generally
a second car for richer, environmentally minded drivers, prepared to pay a big premium for a vehicle with a
battery that took an age to charge and had a limited range. The falling cost of batteries will make the cost of
owning and running an EV the same as that of a traditionally powered car in Europe by the early 2020s, even
without the hefty government subsidies that many rich countries use to sweeten the deal. Better batteries
should also conquer ‘range anxiety’—most pure EVs now run out of juice after around 100 miles (161km). If
battery costs continue to tumble and performance improves at the current rate, the price of a car with a range
of 300 miles could be around £23,000 ($30,000) by the early 2020s, according to Exane BNP Paribas. Slicker
technology will also mean charging in minutes, not hours.
The lack of charging infrastructure still deters buyers, but signs of growth are encouraging. In most rich
countries governments, car makers and private companies are putting up the necessary cash. In the US, the
number of charging points grew by more than one-quarter to almost 40,000 in 2016. Even Shell and Total, are
planning to put chargers on the forecourts of their petrol stations across Europe.
But EVs are not yet a profitable business for car makers, precisely because of their batteries. Tesla’s Model 3,
is set to go on sale in 2017; the firm has yet to make an annual profit. Even Renault-Nissan, the world’s biggest
EV manufacturer, loses money on electric models. Research and development also costs a fortune. Daimler
says it will have spent €10bn by 2025 on just ten battery-powered models. Restructuring is also expensive. For
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a century, car makers have built factories, employed workers, and developed a supply chain around the ICE. In
one scenario Morgan Stanley reckons that VW’s entire car business could make a loss between 2025 and 2028,
as it transforms itself.
Some car makers are better placed than others for the transition. Profitable premium brands such as Daimler
and BMW have the resources to invest and can be confident that their richer customers will be the first to switch
to more expensive EVs. Mass-market car makers have a trickier task; despite falling costs, a cheap EV for the mass
market is still a distance away. The likes of Fiat Chrysler or PSA Group, which makes Peugeots and Citroëns, have
barely begun to change. But these car makers, already operating with wafer-thin profit margins, must still invest
heavily in anticipation of that moment.
EVs may eventually make more money than ICE cars as battery costs fall further. They are competitive in
other ways too: EVs are simpler mechanically, and require less equipment and fewer workers to assemble them.
But car makers first face a transition that will hit cash flow and profits. Getting ready for an electric race will be
painful, but missing it altogether would be disastrous.
Source: ‘Volts wagons: Electric cars are set to arrive far more speedily than anticipated’, The Economist, 18 February 2017. Reproduced with permission.
2.4.5 Limitations of PEST Analysis
PEST analysis is not simply writing a ‘shopping list’, the use of disparate bullet points without any consideration of their
wider ramifications. In listing PEST factors, one must clearly exercise judgement to draw out the implications of each
factor on the organization’s industry. Furthermore, the rate of change of PEST factors in the macro-environment and
their increasing unpredictability may act to limit the use of PEST analysis. Porter, we noted, argues that the industry
is the only true arena for the organization to analyse, since it is the industry which has the greatest impact on a firm’s
markets and products.24 Whilst there is agreement that the industry in which a firm competes has the greatest effect
on its ability to achieve competitive advantage, it would be unwise to refrain from analysing the macro-environment
for nascent changes.
For information on how to write a PEST analysis, go to the online resources and see the Working
through Strategy feature for this chapter.
www.oup.com/uk/henry3e/
2.5 An Introduction to SWOT Analysis
SWOT analysis refers to strengths, weaknesses, opportunities, and threats. Strengths and weaknesses refer to the
organization’s internal environment over which the firm has control. Strengths are areas where the organization excels
or has a competitive advantage in comparison with its competitors, while weaknesses are areas where the organization is at a competitive disadvantage. Opportunities and threats manifest themselves in the organization’s external
environment, over which it has less control. SWOT may be used in both the macro-environment and at the industry
level. However, the unpredictable nature of events in the macro-environment tends to make the use of SWOT analysis
more problematic.
Taken together, scenario planning and PEST analysis can help managers identify the external opportunities and
threats (OT) facing an organization. The firm’s internal strengths and weaknesses (SW) can best be determined
CHAPTER 2 Evaluating the Macro-Environment
51
2.6 The Macro-environment and Industry Analysis
By making the links between the macro-environment and industry analysis explicit, an organization can conduct its
analyses in more depth by assessing its ability to deal with the impact of these trends on its industries and markets.
To be of benefit, these macro-environment factors require constant and structured monitoring. They should be seen
as an additional framework in which to detect the important weak signals that coalesce into discernible patterns and
foretell structural changes in an industry. In this respect, both scenario planning and PEST have an important role to
play in identifying the disruptions that will have the greatest impact on an organization’s competitive environment.
Although the macro-environment and industry analysis are discussed in separate chapters, it may be helpful to think
of them as part of the same continuum. Seen in this way the analysis undertaken simply moves an organization further
along this continuum.
Summary
All organizations need to be aware of the events taking place in their macro-environment and understand what impact
these might have on their industry and markets. Changes in the macro-environment can affect the way existing organizations compete and cause new industries to emerge. Therefore, it becomes important for organizations to scan and
monitor their macro-environment in order to detect signs of change. We have seen that weak signals, which are often
difficult to detect, may act as a precursor of disruptions. These disruptions may arise as a result of step changes in technology, for example, and represent structural changes that will have an impact on an organization’s industry.
The use of scenario planning is relevant here to help the organization develop different ways of thinking about its
environment. Scenario planning involves developing a challenging, plausible, and internally consistent view of what
the future might turn out to be. A major benefit of scenarios is to help organizations recognize the weak signals that
signpost change in the environment, and to enable managers to question the assumptions they hold about the nature
of competition.
PEST analysis is also used for making sense of an organization’s macro-environment. By monitoring changes in PEST
factors the organization is better able to position itself to take advantage of opportunities and mitigate threats.
SWOT analysis deals with the strengths and weaknesses in the internal environment of the organization, and the
opportunities and threats in its external environment. It can be applied when an organization has undertaken an analysis of its macro-environment using PEST analysis, to identify opportunities and threats. And also, after an appraisal of
2
following an appraisal of its own resources and capabilities. SWOT analysis allows an organization to assess the relevance of its current strategy in light of changes to industry conditions. It is readily understood within organizations
as managers seek to turn potential threats into opportunities and weaknesses into strengths. There is some disagreement as to whether it is the external analysis which precedes the internal analysis of a firm’s resources and capabilities, or vice versa. We discuss this in detail when we look at the resource-based view of strategy in Chapter 5. We can
say that SWOT analysis is best undertaken once an audit of the macro-environment and the organization’s own internal resources and capabilities have been completed. With this in mind, we will revisit SWOT analysis in Chapter 4.
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PART TWO Strategic Analysis
2
its internal capabilities to determine its strengths and weaknesses, and therefore its ability to handle external threats
and opportunities.
We have seen that a relationship exists between the macro-environment and the competitive or industry environment. Events taking place in the macro-environment will eventually find their way into an organization’s industry.
Therefore, scanning and monitoring the macro-environment using scenario planning and PEST will benefit the organization in its competitive environment. It allows senior managers to periodically test the mental business models they
hold. Finally, disruptive technological trends can be detected and acted upon before they rewrite how an organization
competes in its industry.
CASE EXAMPLE Disruptive Innovation from Netflix
Introduction
Netflix was co-founded in 1997 by Reed Hastings and Mark
Randolph. At that time, they were offering customers the
opportunity to rent movies delivered by mail for a flat fee.
The story goes that Hastings got the idea for Netflix only
after he received a large late fee for a film he rented from
his video store in California. Hastings had lost the film and
after searching for six weeks had to pay up $40. Later, on his
way to the gym, he reflected on the gym’s business model;
you pay a set fee and work out as little or as much as you
want. This became Netflix’s offering; that customers can Netflix is the world’s leading internet television network,
with over 100 million members in over 190 countries.
rent a DVD for as long as they like and no late fees are ever Source: © Diabluses/Shutterstock.com
charged.
Netflix has gone through a number of changes since it began in 1997 as a DVD mail order service. The company has navigated the change from DVDs to streaming to becoming a global TV network. The dominant competitor during its inception, Blockbuster, has long since gone bankrupt. Today, Netflix is the world’s leading
internet television network, with over 100 million members in over 190 countries enjoying more than 125
million hours of TV shows and movies per day. This includes original series, documentaries, and feature films.
Netflix members pay a subscription to watch as much as they want, anytime, anywhere, on nearly any internetconnected screen. Members can play, pause, and resume watching, all without commercials or commitments.
Was it inevitable that Netflix’s way of doing business would succeed over Blockbuster’s and it’s use of streaming technology become the dominant format? Were there any signals which might have warned Blockbuster
of a potentially disruptive technology? The truth is, something always exists which might point to a change in
competitive conditions. However, senior managers need to open their eyes to perceive the change.
Competitors in the Same Market
In 2000, Netflix was little more than an incipient start-up. Far from making any money, the company was incurring increasing losses. The CEO, Reed Hastings, flew to Dallas to propose a partnership with Blockbuster CEO,
John Antioco. Blockbuster was the established competitor in the market. A year earlier, Netflix had revised its
business model from customers paying for each DVD they rented to a subscription service, which worked better
for consumers. Hastings’ proposal to Blockbuster was simple. He was offering to sell Netflix to Blockbuster for
$50 million. As part of the deal, Netflix would run the Blockbuster brand online and Antioco would promote
Netflix in its store. On the face of it, the idea made sense; Netflix was an online retailer, while Blockbuster had a
bricks-and-mortar presence. Why not try to expand the DVD market by helping each other? However, given its
loss-making business, Hastings and his team were laughed out of the office. Within ten years Hastings would
have the last laugh.
Back in 2000, Blockbuster was the dominant player within the video rental industry. It had access to more
than 9,000 retail stores across America and 528 stores, at its peak, in the UK. It had millions of customers, a
massive marketing budget, and efficient operations. Viewed from this perspective, the approach from Hastings seemed to be asking Mr Antioco to hand over the brand they had worked hard to build. The trouble with
Blockbuster’s business model wasn’t entirely clear at that time, but it could be seen if you looked hard enough.
The company’s profits were heavily dependent on the late fees it charges its customers. Netflix, in contrast, had
no retail locations, which reduced its costs. And, as it charged customers a subscription for its DVDs, this made
late fees redundant. Once a customer paid their subscription, it was up to the customer to decide how long
they wanted to keep the DVD. At the same time, they could return their DVDs and cancel their subscription.
Competing in Different Ways
A major advantage of Blockbuster was that the customer could walk into a store and immediately rent a DVD.
With Netflix, customers received their DVDs by post which was slow in comparison to Blockbuster. Also, the
Netflix brand was not as developed as Blockbuster’s, making it more difficult for consumers to find. However, as
resistance to the Netflix model for renting DVDs was overcome, it would reach a tipping point. This occurred as
existing customers shared their enthusiasm for the Netflix service with their friends and family. If Blockbuster
was to compete effectively with Netflix, it would have to change its mode of doing business. It’s easy to think,
‘Why do this, why incur a fall in profit just because a small, niche player is operating in the market?’ Nevertheless, Blockbuster had an opportunity to recognize that Netflix’s customer offering might cause the video rental
industry to evolve in a manner which put it at a disadvantage.
They were faced with a choice of monitoring the changes taking place around them or simply continuing
with business as usual. Of blindly believing what has worked in the past will continue to work in the future.
Unfortunately, for Blockbuster this was
not to be the case. Blockbuster’s US parent
company filed for Chapter 11 bankruptcy
protection in 2010. It was subsequently
acquired by Dish Network through a bankruptcy auction in 2011. By 2013, both
US and UK Blockbuster businesses were
placed in administration. Was this inevitable? Perhaps not? There were signals there
to detect if Blockbuster had been scanning
its environment and monitoring for signs
of change or disruption.
Blockbuster is not the only competitor By 2013, both US and UK Blockbuster businesses had been placed in
to underrate Netflix and other streaming administration. Source: © JLRphotography/Shutterstock.com
53
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CHAPTER 2 Evaluating the Macro-Environment
2
54
PART TWO Strategic Analysis
providers. In 2007 Netflix introduced streaming, which allows members to instantly watch TV shows and films
on their personal computers. By 2010 it had partnered with consumer electronics companies to stream on the
Xbox 360, PS3, Internet-connected TVs, and other Internet-connected devices, including Apple devices. In the
same year, executives from the cable and entertainment industry predicted that the early success of Netflix’s
streaming service would be short-lived. Their argument was that Netflix’s supply of content from film studios
and TV networks would soon slow down to a trickle. Around 2013, Netflix executives began to wonder if the
days of licensing a back catalogue of great TV shows cheaply might be coming to an end. TV and film companies
were starting to realize how valuable streaming rights were, which meant that getting them would become
increasingly difficult for Netflix. Netflix made the decision that it would have to start making its own shows and
movies, starting with ‘House of Cards’.
The huge investment Netflix has made in its ‘originals’ over the past few years has paid off in a string of hits
which has won consumer loyalty and industry accolades, including a Golden Globe. By 2017, Netflix’s market
capitalization had risen to a staggering £49bn ($64bn). For Blockbuster, it was a case of the ‘innovator’s dilemma’;
you end up competing with a business which you initially ignored. Unfortunately for Blockbuster, this realization came too late for their executive team to make a difference.
Questions
1. Identify the weak signals which were available to Blockbuster before it went bankrupt.
2. To what extent was Netflix a disruptive innovator for Blockbuster?
Sources: Greg Sandoval, ‘Blockbuster laughed at Netflix partnership offer’, www.cnet.com, 9 December 2010; Brian Stelter, ‘Internet kills the video store’, www.
nytimes.com, 6 November 2013; ‘Blockbuster to shut a quarter of UK stores’, The Guardian, 14 November 2013; Greg Satell, ‘A look back at why Blockbuster really
failed and why he didn’t have to’, Forbes, 5 September 2014; Nathan McAlone, ‘Netflix’s website in 1999 looked nothing like it does today’, ukbusinessinsider.
com, 25 April 2016; ‘Netflix’s content chief said something about its ‘originals’ that should make investors optimistic about the future’, ukbusinessinsider.com,
23 April 2017; www.wikipedia.org; www.netflix.com
Review Questions
1. Explain the role that weak signals play in helping managers to understand potential changes in their
macro-environment.
2. Why might PEST analysis be more appropriate for an organization than scenario planning?
Discussion Question
Scenario planning is little more than an educated guess. Discuss.
Research Topics
1. Develop two plausible scenarios for the UK high street retailer, W. H. Smith.
2. Describe the theory of the business on which Blockbuster and Netflix was based. Explain how this resulted in
Blockbuster going bankrupt and Netflix dominating film and TV streaming.
CHAPTER 2 Evaluating the Macro-Environment
55
Recommended Reading
Two books that deal with the use of scenario planning in the macro-environment and the competitive
environment are:
●
M. E. Porter, Competitive Advantage, chapter 13, Free Press, 1985.
K. van der Heijden, Scenarios: The Art of Strategic Conversation, Wiley, 1996.
For a discussion of how to undertake scenario planning and its benefits, see:
●
P. J. H. Schoemaker, ‘Scenario planning: a tool for strategic thinking’, Sloan Management Review, vol. 36, no. 2
(1995), pp. 25–40.
For an interesting read on the effects of weak signals, see:
● M. Gladwell, The Tipping Point, Abacus, 2000.
www.oup.com/uk/henry3e/
Visit the online resources that accompany this book for activities and more information on the
macro-environment.
References and Notes
1
See https://gizmodo.com/why-we-still-use-qwerty-keyboards-even-though-theyre-a-1643855077.
2
P. Ginter and J. Duncan, ‘Macroenvironmental analysis for strategic management’, Long Range Planning,
vol. 23, no. 6 (1990), pp. 91–100.
3
Remarks made by Donald Rumsfeld, former US Secretary of Defense at a Department of Defense news
briefing on 12th February 2002.
4
C. M. Christensen, M. E. Raynor, and R. MacDonald, ‘What is disruptive innovation?’, Harvard Business
Review, vol. 93, no. 12 (2015), pp. 44–53.
5
J. Bower and C. M. Christensen, ‘Disruptive technologies: catching the wave’, Harvard Business Review,
January–February (1995), pp. 43–53.
6
Quoted in D. Mercer, Marketing Strategy: The Challenge of the External Environment, Open University, 1998.
7
Quoted in Mercer, n. 6.
8
J. B. Soll, K. L. Milkman, and J. W. Payne, ‘Outsmart your own biases’, Harvard Business Review, May (2015),
pp. 65–71.
9
J. Beshears and F. Gino, ‘Leaders as decision architects’, Harvard Business Review, May (2015), pp. 52–62.
10
H. I. Ansoff, Implementing Strategic Management, Prentice Hall, 1984.
11
K. van der Heijden, Scenarios: The Art of Strategic Conversation, Wiley, 1996.
12
P. J. H. Schoemaker, ‘Scenario planning: a tool for strategic thinking’, Sloan Management Review, vol. 36, no. 2
(1995), pp. 25–40.
13
M. E. Porter, Competitive Advantage, Free Press, 1985, p. 446.
14
Schoemaker, n. 12.
2
●
PART TWO Strategic Analysis
15
A. Kahane, ‘Scenario for energy: a sustainable world vs. global mercantilism’, Long Range Planning, vol. 25,
no. 4 (1992), pp 38–46. See also A. Kahane, Transformative Scenario Planning: Working Together to Change the
Future, Berrett-Koehler, 2012.
16
See G. Morgan, Riding the Cutting Edge, Josey Base, 1988 and A. Grove, Only the Paranoid Survive, Random
House, 1996.
17
M. Gladwell, The Tipping Point, Abacus, 2000. The tipping point is the moment of critical mass, the threshold,
the boiling point at which an idea, trend or other social phenomenon goes viral.
18
For a brief discussion of decision making under conditions of uncertainty, see R. Gertner, ‘Scenario analysis:
telling a good story’, in Mastering Strategy, Prentice Hall, 2000, 245–50.
19
Section 2.3.1, ‘How to Build Scenarios’ is based on Schoemaker, n. 12.
20
See Schoemaker, n. 12, p. 27.
21
For a discussion on why Porter believes scenario planning is best applied at an industry level, see Porter,
n. 13, p. 447.
22
See https://www.theguardian.com/uk-news/2016/mar/16/budget-2016-george-osborne-sugar-taxmixed-response. For a discussion of the beneficial effects of a sugar tax in different countries, see http://www.
telegraph.co.uk/food-and-drink/news/sugar-tax-what-does-it-mean-and-who-will-be-affected/.
23
M. E. Porter and C. van der Linde, ‘Green and competitive: ending the stalemate’, Harvard Business Review,
vol. 73, no. 5, pp. 120–33.
24
See Porter, n. 13, chapter 13.
2
56
CHAPTER 3
INDUSTRY ANALYSIS
3.1 The
Background to Porter’s
Five Forces Framework
3.2 Porter’s
Five Forces
Framework
3.3 Limitations
of Porter’s
Five Forces
3.4 The
Value Net
Working through
Strategy
Undertaking
Porter’s five forces
analysis
Main Reference
Porter, M.E. (1980).
Competitive Strategy: Techniques
for Analysing Industries and
Competitors.
Free Press, New York.
3.5 The
Industry
Life Cycle
3.6 Strategic
Groups
Extension Material
Strategic groups
C. M.
Christensen, M. E. Raynor,
and R. McDonald,
‘What is disruptive innovation?’,
Harvard Business Review, vol.
93, no. 12 (2015), pp. 44–53.
Learning Objectives
After completing this chapter you should be able to:
●
●
●
●
●
●
3.7 Hypercompetition
and Disruptive
Innovation
Explain the importance of industry analysis
Evaluate Porter’s five forces framework as a tool of industry analysis
Discuss the value net and the role of complementors in creating value for
organizations
Explain the industry life cycle
Analyse strategic groups within an industry
Explain the impact of hypercompetition and disruptive innovation on industry
dynamics
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PART TWO Strategic Analysis
Introduction
3
The external environment facing an organization consists of a macro-environment and a competitive environment.
Any changes that occur in the macro-environment have the potential to impact upon an organization’s competitive
environment. Therefore, it is important that organizations scan and monitor their macro-environment to discern weak
signals that have the ability to affect or fundamentally change the industry within which they compete. The macroenvironment was discussed in Chapter 2. In this chapter we assess the impact of the competitive environment and
how an organization might achieve competitive advantage.
It is widely accepted that the nature of competition in an industry is more directly influenced by developments taking
place in the competitive environment. This is not to suggest that the macro-environment is unimportant but that its
impact is often less obvious than events taking place in the competitive environment. In this chapter we look at some
of the tools of analysis available to analyse industries. We discuss Michael Porter’s approach to competitive strategy
and focus on his structural analysis of industries: the five forces framework. The strategy formulations emanating from
the five forces framework are discussed in detail in Chapter 7, when we consider business strategy.
3.1 The Background to Porter’s Five Forces
Framework
Michael Porter’s ideas on competitive strategy include some of the most pervasive analytical tools used in strategic
management.1 In the 1970s Michael Porter was working with two different disciplines—business policy (strategy) and
industrial organization. Both disciplines involved evaluating industries and therefore had common issues but they
remained very much separate subject areas. Porter recognized that an opportunity existed to bring thinking about
industrial organization into strategy, and thinking about strategy into industrial organization. To further understanding in this field, he made use of frameworks.2
In framework building, the skill is to use the smallest number of core elements that still capture the wide variation that
takes place between organizations in competition. As Porter recognized, these dimensions have to be intuitive; they
must make sense to practitioners in the context of their own industry. Porter’s contribution was to develop a framework
for analysing industries that could be generalized from a few core elements, in this case five—hence the five forces framework. The five forces framework is an attempt to capture the variation of competition, while being pervasive and rigorous.
His insight is that organizations seeking above-average profits should not just react to their competitive environment,
but should actively seek to shape it. However, as we shall see, Porter’s five forces framework is not without its critics.
3.2 Porter’s Five Forces Framework
The five forces framework is undertaken from the perspective of an incumbent organization; that is, an organization
already operating in the industry.3 An industry is a group of organizations producing a similar product or service. The
analysis is best used at the level of an organization’s strategic business unit (SBU). Typically, a strategic business unit
CHAPTER 3 Industry Analysis
59
Although the five forces analysis is undertaken from the perspective of an incumbent firm, it can be used to determine whether a firm outside an industry should enter the industry. In this case the barriers to entry which may be
protecting the incumbents is an additional cost that outsiders must factor into their analysis of whether to enter
the industry. An organization thinking of entering an industry will need to know that it can successfully compete with incumbents in the industry. This will require it to adopt a distinctive positioning. For example, Amazon
entered book retailing by utilizing the Internet to create support activities which provide a sustainable competitive advantage.
The five forces framework is an analytical tool for assessing the competitive environment. The competitive environment is the industry or market in which an organization competes. It enables an organization to determine
the attractiveness or profit potential of a particular industry by examining the interaction of five competitive
forces. It is the combined strength of these five forces which will ultimately determine an organization’s return
on investment or the potential for profits within a given industry. The five forces are (1) threat of new entrants;
(2) bargaining power of buyers; (3) bargaining power of suppliers; (4) threat of substitute products or services; and
(5) intensity of rivalry among firms in an industry. By examining all five competitive forces an organization is
able to assess its ability to compete effectively in an industry. The five forces framework is based on an economic theory known as the ‘structure–conduct–performance’ (SCP) model. This states that the structure of an
industry determines an organization’s competitive behaviour (conduct), which in turn determines its profitability
(performance).
The five forces framework is a rigorous approach to looking at industries and where organizations stand in relation
to the structural forces prevalent in that industry.4 In this respect it differs from SWOT analysis, which was introduced in Chapter 2, and is further explored in Chapter 4. SWOT analysis is company-specific, while Porter’s five
forces is industry-specific. The five forces framework allows an organization to make informed decisions, given
its resources, about whether existing competition, bargaining power of suppliers, bargaining power of buyers,
threat of new entrants, and threat of substitutes make this industry an attractive (profitable) one to compete in.
Using Porter’s five forces, an incumbent organization can, for example, decide that industry conditions suggest that it
would be more beneficial to use its resources and capabilities in an alternative industry; that is, it should exit the industry, or at least decrease its resource commitment to that industry. The five forces framework also enables an organization to improve its competitive positive in relation to industry trends. For example, an awareness of a trend towards
consolidation among suppliers (leading to an increase in supplier power) might lead an organization to strengthen
its relationships with its existing supplier to avoid downward pressures on its profit margins. Therefore, accurately
estimating future trends in the five forces should also provide an organization with an indication of future profits in
the industry.
3
exists when a diversified corporation serves several different markets. Each SBU will be responsible for the strategies
to compete in that market. For example, HSBC has a cards business that is responsible for competing in their credit
and debit card market against competitors such as Barclays. Although each organization in an industry is unique, the
forces within the industry which affect its performance, and hence its profitability, will be common to all organizations
in the industry. It is in this sense that Porter’s contribution is pervasive—the ability to generalize these five forces to all
organizations within the industry.
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PART TWO Strategic Analysis
3
Clearly, if the five forces do not have the same impact upon different industries then we would expect different industries to exhibit different levels of profit. Similarly, within an industry each of these five competitive forces will have a
different impact on the industry structure. For Porter, the aim of competitive strategy is to find a position within the
industry that an organization can effectively defend against the impact of the five forces, or to try to influence the five
forces in its favour. In evaluating the five forces, managers need to be aware that each competitive force will have a different effect on their industry. Therefore, managers need to understand the relative impact of each of the five forces on
their industry structure. They can then ascertain their ability to influence the forces with the greatest impact on their
industry structure through their strategy formulation. Their ability to change the industry structure will be in direct
proportion to their influence over the five forces.
The five forces framework of industry competition is shown in Figure 3.1. We can discuss each of the constituent elements that make up the five forces to ascertain their potential impact on industry profitability.
3.2.1 The Threat of New Entrants
The threat of new entrants is the extent to which new competitors may decide to enter an industry and reduce the
level of profits being earned by incumbent firms. Where organizations in an industry earn profits well in excess of their
cost of capital, the more likely it is to attract new entrants. The problem for many industries is that they are too easy to
enter—and the easier it is for new organizations to enter the industry, the greater the excess capacity and the more
intense the competition.
The threat of entry will depend on the existence of barriers to entry and the reaction of existing competitors. If entry
barriers are high, the threat of entry to the industry by new organizations will be low. Similarly, if a new entrant
expects that existing firms will retaliate, for example by lowering their price, this will act to deter the firm from entering the market.
The main barriers to entry include economies of scale, capital requirement, product differentiation, access to distribution channels, and cost advantages independent of size.
Potential Entrants
Bargaining
power of
suppliers
Suppliers
Threat of new
Bargaining
entrants
power of
buyers
Industry Competitors
Rivalry among existing firms
Buyers
Threat of substitute
products or services
Substitutes
Figure 3.1 Porter’s five forces framework of industry competition. Source: Reprinted with permission of The Free Press, a Division of Simon & Schuster Inc., from
Michael E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors, Free Press. Copyright © 1980, 1998 by The Free Press. All rights reserved.
61
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CHAPTER 3 Industry Analysis
The car manufacturing industry is an example of an economy of scale. Source: © xieyuliang/Shutterstock.com
Economies of Scale
Economies of scale occur when the cost of each individual unit produced falls as the total number of units produced
increases. Economies of scale tend to be associated with manufacturing organizations, since the high capital costs
of their plant need to be recovered over a high volume of output. In industries such as chemicals, automobiles, and
aerospace large-scale production is imperative to achieve efficiency. The effect of economies of scale is to deter new
entrants because it forces them to choose between two undesirable options: (1) either they enter the industry at a high
volume of output and risk a strong reaction (retaliation) from existing organizations; or (2) they enter the industry at a
small scale, avoiding retaliation from existing firms, but operating at a cost disadvantage.
Capital Requirements
If organizations need to invest substantial financial resources to compete in an industry, this creates a barrier to entry.
For example, organizations wishing to enter the oil industry would face huge capital costs involved in exploration and
in specialist plant and machinery. This entry barrier is further strengthened because the major oil companies are vertically integrated. They compete in different stages of production and distribution; that is, both upstream (extraction of
oil) and downstream (sale of products to the consumer).
Product Differentiation
Where an organization’s products are already established in an industry, providing it with high brand awareness and
generating customer loyalty, new entrants will have to spend disproportionately on advertising and promotion to
establish their product.
PART TWO Strategic Analysis
3
62
Kellogg’s range of cereals is a good example of established products dominating an industry. Source: © Everything/Shutterstock
Access to Distribution Channels
A new entrant will need to have access to distribution for its product in order to compete successfully in the industry.
For example, Haagen-Dazs tried to prevent Ben & Jerry’s from successfully competing in the luxury segment of the ice
cream market by having sole agreements with distributors.
Cost Advantages Independent of Size
Some competitors within an industry may possess advantages that are independent of size or economies of scale.
They may benefit from early entry into the market and associated ‘first-mover’ advantages. The early experience that
such firms acquire may make it difficult for new entrants to imitate their success. Other cost advantages include government policies that may favour incumbent firms, favourable low cost access to raw materials, and the use of patents
to protect proprietary knowledge.5
3.2.2 The Bargaining Power of Buyers
Buyers can affect an industry through their ability to force down prices, bargain for higher quality or more services, and
to play competitors off against each other. This power of buyers will reflect the extent to which their purchase represents
a sizeable proportion of the organization’s overall sales. The power of buyers is increased in the following circumstances.
Concentration of Buyers and High Volumes
Where there is a concentration of buyers in relation to the number of suppliers, and the volume purchase of any one
buyer is high, the importance of the buyer’s business to the supplier increases. For example, Wal-Mart, the world’s
largest retailer, is able to exert pressure on its suppliers’ margins because of the size of the purchases it makes and the
CHAPTER 3 Industry Analysis
63
importance of these huge purchases to the suppliers. In the UK, suppliers of farm produce have long complained that
the concentration of supermarket purchases allows them to drive down margins for their products.
Purchases are Standard or Undifferentiated
When they are dealing with a standard or undifferentiated product, buyers are confident that they can always find
alternative suppliers. Because the product is standard, buyers exert pressure on price rather than product features as
they play one competitor off against its rival. For example, the price of steel worldwide is subject to downward pressure, as buyers can simply purchase this commoditized product at the lowest price.
Where the costs to the buyer of switching supplier is low or involves few risks, the buyer’s bargaining power is
enhanced. Clearly, undifferentiated products benefit buyers as the cost of switching is low.
There is a Threat of Backward Integration
When buyers have the ability to integrate backwards (that is, to supply the product or service themselves), they pose a
threat to the supplier which will strengthen their bargaining position. For example, Coca-Cola and Pepsi Cola engage
in tapered integration. They operate their own bottling subsidiaries while also using independent contractors to bottle and distribute their products. That way, both companies can threaten to use their own production capacity more
intensively, thereby extracting favourable terms from their bottling suppliers.
3.2.3 The Bargaining Power of Suppliers
Suppliers can exert bargaining power over participants in an industry by raising prices or reducing the quality of purchased goods and services. The factors that increase supplier power are the mirror image of those that increase buyer
power. The supplier is the producer of an organization’s inputs for making goods and services. Suppliers are powerful
under the following circumstances.
Concentration of Suppliers
The larger the supplier, and the more dominant it is, the more pressure it can place on firms in the industry it sells to.
This is especially the case where a supplier is selling to many fragmented buyers.
Suppliers are Faced with few substitutes
Where there are few or no substitute supplies available the supplier will be in a powerful position. Intel faces few substitutes for its highly differentiated product allowing it to charge premium prices for its microprocessors.
Differentiated Products and High Switching Costs
If switching to other suppliers will prove difficult and costly for buyers, this prevents them playing one supplier off
against another. This may arise because a buyer’s product specifications tie it to a particular supplier.
Threat of Forward Integration
When suppliers have the ability to integrate forwards into the buyers’ industry and compete with their buyers, this will
act to reduce profitability in the buyers’ industry. This threat reduces the organization’s ability to negotiate lower prices
from their suppliers.
3
Switching Costs are Low
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PART TWO Strategic Analysis
3.2.4 The Threat of Substitute Products and Services
This is not competition from new entrants but from different products or services which can meet similar consumer
needs. By placing a ceiling on the prices organizations in the industry can profitably charge, substitutes limit the
potential returns of an industry. The existence of substitutes means that customers can switch to these substitutes in
response to a price increase by firms in industry. The threat of substitute is determined by:
3
The Price–Performance Ratio
The more attractive the price–performance ratio of substitute products, the greater the restraint on the prices that can
be charged and therefore on an industry’s profits. An attractive price–performance ratio could be a substitute product
that is of a higher quality, even if it comes at a higher price. For example, the cost of travel to France via the Channel Tunnel is more expensive than a ferry crossing, but the convenience in time saved makes it a viable substitute. In trying to
determine a substitute product, the organization will need to identify products which can perform the same function as
its own product.
3.2.5 The Intensity of Rivalry among Competitors in an Industry
A key determinant of the attractiveness of an industry is rivalry among incumbent or existing organizations in the
industry. Where a high degree of rivalry exists, this causes industry profits to be reduced. Such rivalry may take the
form of competing aggressively on price. Price cuts can easily be matched by rivals and ultimately lowers profits for all
organizations in the industry. In contrast, advertising, product innovations, and improved customer service may act to
expand overall demand in the industry.
Rivalry can increase when competitors in an industry see an opportunity to improve their market position. However,
this will invariably be met by retaliatory moves from other organizations in the industry. The following factors affect
competitive rivalry:
Numerous or Equally Balanced Competitors
Where there are few competitors in an industry and they are of a similar size, there is likely to be intense competition as
each competitor fights for market dominance. This is often seen in oligopolistic markets, where a few firms dominate
the market. Examples include supermarket retailers, investment banks, and pharmaceuticals.
Industry Growth Rate
When an industry is characterized by slow growth, an organization can only increase its market share at the expense of
competitors in that industry. This will be resisted by competitors, resulting in more intense competition.
High Fixed Costs
High fixed costs in an industry create pressure for organizations to increase their capacity to gain economies of scale.
Where the demand conditions will allow only some firms in the industry to reach the volume of sales required to
achieve scale economies, this will engender a fight for market share. The excess capacity in the industry usually results
in a price war. An example is the airline industry.
CHAPTER 3 Industry Analysis
65
Lack of Differentiation
Where products are undifferentiated competition will be more intense, driven by customer choice based on price and
service. Lack of switching costs implies that competitors are unable to prevent customers from going to their rivals.
High Exit Barriers
3.2.6 Competing Using the Five Forces Framework
Porter’s five forces framework can help organizations to understand the attractiveness or profit potential of their industry. This is achieved by analysing the relative impact of each of the five forces on their industry structure. ­Organizations
can then formulate a strategy which defends their position in relation to the five forces. Furthermore, organizations
should seek to devise a strategy that will actively influence these five competitive forces in their favour. Porter’s five
forces framework works best when used at the level of the strategic business unit.
To succeed, organizations need only to compete in industries with few competitors, low bargaining power of buyers
and suppliers, and where the threat of new entrants and substitutes is minimal. This is unlikely to be achieved, particularly in today’s global environment. In reality, organizations need to compete in industries where their resources
and capabilities provide them with a strategic fit with their competitive environment . See Case Example: Ryanair:
How to compete in the airline industry. Porter’s work on strategy formulation includes three generic strategies:
overall cost leadership, differentiation, and focus. These strategies enable an organization to position itself against
the five forces.6 These generic strategies are discussed in Chapter 7.
For help when undertaking Porter’s five forces analysis, visit the online resources and see the
Working through Strategy feature for this chapter.
www.oup.com/uk/henry3e/
3.3 Limitations of Porter’s Five Forces
Some criticisms of Porter’s five forces, such as the concept of complements by Adam Brandenburger and Barry Nalebuff,7 can be seen as an attempt to expand and improve the framework.
1. The five forces framework assumes a zero-sum game; that is, competitors can only succeed at the expense of
other players in the industry. However, organizations are increasingly aware of the added value that other players,
such as suppliers (and indeed competitors), can contribute. For example, in the automobile industry Toyota and
Honda work closely with their suppliers to ensure that parts are available at the right price, of the exact quality,
and only when needed in order to reduce inventory and associated costs.
3
The existence of high exit barriers may hinder firms needing to exit the industry. For example, some plants are so specialized that they cannot easily be used to produce alternative goods. As demand conditions deteriorate, this creates
excess capacity in the industry which acts to reduce profitability.
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PART TWO Strategic Analysis
2. The five forces framework is a static analysis which assumes relatively stable markets. It tells us little about how
players in the industry interact with each other and the effects of actual and anticipated competitor moves on
an organization’s decision making. C. K. Prahalad8 states that organizations face significant and discontinuous
change in their competitive environment.9 He argues the disruptive forces which have brought about this change
are accelerating. For Prahalad, strategy is not about positioning the company in a given industry space, but influencing and actually creating industry space.
3
3. Mintzberg and Waters10 argue that organizations may develop an intended or deliberate strategy, but unexpected changes in the environment may force them to abandon that strategy. A subsequent strategy emerges as
a result of ad hoc management decision making. Furthermore, in emerging industries you do not know who your
rivals are, which makes the use of the five forces framework problematic.
4. Why are there only five forces? Some have argued that other forces, in addition to the five forces, are required. For
example, the government has been put forward as one possible candidate.
5. A revision of the five forces is required which brings us closer to a dynamic theory of strategy. Brandenburger
and Nalebuff11 utilize game theory to show how organizations can collaborate as well as compete with their
competitors to create a larger industry in which everyone gains. This is referred to as co-opetition, which we
discuss below.
Perhaps, not surprisingly, Porter tends to reject these criticisms particularly the notion that his framework is static.12 He
does, however, accept that there may be a role for Brandenburger and Nalebuff’s work in the five forces.13
3.4 The Value Net
In an extension of Porter’s five forces, Brandenburger and Nalebuff 14 use game theory to capture the dynamic nature
of markets in their analysis. They developed the value net that more closely represents the complexity in an industry.
The value net represents a map of the industry, the players in the industry, and their relationship to each other. This
is illustrated in Figure 3.2. In seeing business as a game, they do not mean traditional games, such as chess, where
there are winners and losers. Since in business success for one player can also mean success for another player, there
can be win–win solutions. They also recognize that in business the rules of the game are not fixed, as in most games,
but that the game itself can be changed. The players in the game are the customers, suppliers, and competitors (where
competitors include rivals, threat of new entrants, and substitute products or services). Brandenburger and Nalebuff
enhance Porter’s five forces by introducing a new player called a complementor.15
Customers
Competitors
Company
Complementors
Suppliers
Figure 3.2 The value net. Source: Reprinted with permission of Harvard Business Review. A. Brandenburger and B. J. Nalebuff, ‘The value net from the
right game: use game theory to shape strategy’, Harvard Business Review, vol. 73, no. 4 (1995). Copyright © 1995 by the Harvard Business School Publishing
Corporation. All rights reserved.
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67
Nintendo’s domination of the video games industry in the 1990s is a useful example of how an organization can successfully add and appropriate value from an industry. Nintendo reduced the bargaining power of its buyers by keeping
its games cartridge in short supply. Although buyers were highly concentrated, Nintendo’s strategy of deliberately
restricting its games cartridge ensured that retailers lost added value. Nintendo’s complementors were the games
developers. To reduce the value accruing to games developers Nintendo developed software in-house. They put security in the hardware and licensed the right to develop games for their system to outside programmers. Therefore,
Nintendo controlled its complementors, reducing their added value, but increasing its own added value through royalties on each game cartridge sold. By utilizing chip technology that was not cutting edge, Nintendo ensured that its
suppliers produced a commoditized product from which they would derive little added value. This allowed Nintendo
to keep the cost of their games console down, which enhanced their market share.
The Irish low cost airline, Ryanair, and Stansted airport are complements. Stansted airport is biggest UK base. Around
eighty per cent of the passengers who pass through the airport fly via Ryanair. In order to get to their flight, passengers
travel through the airport invariably spending at the numerous retail outlets, which provide substantial revenues for Stanstead airport. The more passengers who fly with Ryanair, the greater the opportunity for Stansted to capture that revenue.
The challenge is to find an acceptable way in which this extra revenue is shared; see Strategy in Focus 3.1.
STRATEGY IN FOCUS 3.1 Stansted Airport’s Unhappy
Complementor
Ryanair may have learned to show a little love to its customers but one group of people still gets the more
traditional Ryanair treatment. Onstage in jumper and jeans in front of a crowd of managers at the Airport
Operators Association conference, chief executive Michael O’Leary slouched grumpily in a seat and announced:
‘I’ve got far better things to do than to talk to a bunch of overcharging airports.’
Nonetheless, O’Leary outlined his airline’s plans: to cut fares and fly ever more people. That was, he said, ‘great
news for all the bankers and robbers assembled in this room who will not be reducing their charges, and who
will all be making out like highwaymen and bandits as they continue to see rising passenger numbers at their
airports, rising retail sales and rising restaurant sales. All on the back of the poor stupid Irish who will be carrying
all these people at even lower prices.’
Bitter? Very. But after the tirades, O’Leary shared a dream: ‘I have this vision that in the next five to ten years
fares on Ryanair will be free; in which case the flights will be full, and we will be making our money out of sharing
the airport revenues of all the people who will be running through airports, and getting a share of the shopping
3
An organization is your complementor if customers value your product more when they have that organization’s product than when they have your product alone. An organization is a competitor if customers value your product less
when they have that organization’s product than when they have your product alone.16 For example, Microsoft’s Windows software and Intel’s microprocessors are complements. Without Intel’s innovative microprocessors, Microsoft’s
upgraded software which require faster processing speeds, becomes less valuable to the consumer. By making products
more valuable to the consumer, complementors create greater value for the industry. At the same time, complementors
may use their market position to affect the industry dynamics and the distribution of profits within the industry.
68
PART TWO Strategic Analysis
3
and the retail revenues.’ Could that dream ever become reality? Certainly, the tills have been flowing freely at
Stansted airport, Ryanair’s biggest UK base.
The departure lounge is testament to the possibilities. The short distance to the departure gates can only be
negotiated via a meandering trail through the duty-free. A hard right at Jo Malone takes you straight into the arms
of the Jack Daniel’s boutique, before sniffing the air through a chicane of Lancôme and Estée Lauder, into an oxbow
bend through the fashion stores. Then it’s one last loop through the food and drink—with millions stopping off at
the third-most-lucrative Pret a Manger in Britain for the last decent sandwich before the airline trolley.
The third most lucrative Pret a Manger in Britain in Stanstead’s departure lounge. Source: © Tupungato/Shutterstock.com
This retail spending is the prize O’Leary covets. The airports, however, reckon that Ryanair already gets its share.
The owner of Stansted, Manchester Airports Group, signed a ten-year deal with Ryanair soon after acquiring
the airport for £1.5bn in 2013. In return for more passengers, Ryanair got lower charges. Alongside, the airport
gave the terminal an £80m transformation, adding fifty per cent more space in the departure lounge. And the
airline loosened up its notoriously tight policy on carry-on bags to allow people to bring their shopping aboard.
Almost eighty per cent of Stansted’s passengers now fly with Ryanair, and the airport’s income from
aeronautical charges fell from £148m to £141m in 2016, even as passenger numbers rose by eleven per cent
to 23.1 million. But those two million more people passing through the doors kept shopping, with a higher
average spending of £5.70 per person (including parking)—meaning that Stansted’s overall revenues still rose
a healthy five per cent. Elsewhere, the chief financial officer of Gatwick airport, says: ‘Our overall charges reflect
the money we make in retail and parking: inherently, there is already discount or cross-subsidy there for airlines.’
Gatwick signed its own growth deal with its major customer, easyJet, with ‘quite an incentive’ to bring in
more passengers, particularly in the off-season. Ryanair only flies around one million of the airport’s 43 million
passengers a year, meaning Gatwick’s focus can be on higher levels of service demanded by other airlines, with
correspondingly higher charges (nearer £9).
An aviation consultant said: ‘Ryanair already negotiate the lowest charges, so if they want to share the retail
pie then airports will be reluctant: airports already use that income to subsidise charges. But if airlines can grow
that pie, that would be a very attractive proposition. It would have to go beyond the airline–airport dynamic as
it is today: they would have to jointly sell something new, by convincing airline customers to buy at the airport.’
Source: Gwyn Topham, ‘From low-fare to no-fare: will travel really become free? The Guardian, 26 November 2016. Reproduced with permission..
CHAPTER 3 Industry Analysis
69
In essence, an organization needs to try to create value and a larger market, which is best undertaken by cooperating
with customers and suppliers. At the same time, an organization is concerned with how this larger market is to be
divided; that is, its competitive position. As Brandenburger and Nalebuff suggest, ‘a company has to keep its eye on
both balls, creating and capturing, at the same time’. They call this co-opetition because ‘it combines competition and
cooperation’.17
3.4.1 A Complementary Sixth Force
Some critics of Porter’s five forces have suggested that his framework would benefit from the inclusion of
­government as a sixth force. Porter recognizes that complements have a role to play in competitive analysis.
If we extend Porter’s five forces framework to take account of complements, it evolves as shown in Figure
3.3. The inclusion of complementors into Porter’s five forces makes the framework more defensible because
it adds a dynamic element to the analysis. This allows organizations in the industry to be more aware of their
­interdependencies. Instead of win–lose, there now exists an explicit recognition that a sustainable strategy can
involve both c­ ooperation and competition. There is cooperation among suppliers, organizations, and customers
to create value, and competition in how this value is divided up. The same holds true for complementors and
substitutes. Instead of viewing substitutes as inherently adversarial and complements as friendly, an organization can have elements of cooperation in its interactions with its substitutes and competitive elements with
complementors.
Potential Entrants
Bargaining
power of
suppliers
Suppliers
Complementors
Threat of new
entrants
Industry Competitors
Rivalry among existing firms
Bargaining
power of
buyers
Buyers
Threat of substitute
products or services
Substitutes
Figure 3.3 The inclusion of complementors within Porter’s five forces. Source: Adapted with permission of The Free Press, a Division of Simon & Schuster Inc.,
from Michael E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors, Free Press. Copyright © 1980, 1998 by The Free Press. All rights
reserved.
3
Brandenburger and Nalebuff use the concept of added value to help determine how the profits will be divided.
They argue that in trying to increase your organization’s own complement’s added value, you must also be thinking
of ways in which you can limit the added value of another organization’s complement. A strategy to achieve this
is to create a shortage of your organization’s differentiated product, which builds up its market dominance. At the
same time, you encourage more suppliers of a complementary product into the industry, which has the effect of
commoditizing that product. The reduction in value of the complementary product will ensure that greater profit is
appropriated by your product.
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PART TWO Strategic Analysis
3.5 The Industry Life Cycle
3
The industry life cycle suggests that industries go through four stages of development: introduction, growth, maturity, and decline (see Figure 3.4). There will clearly be variations between different industries as to the length of each
life cycle. McGahan points out that even within an industry different strategic groups may be experiencing different
stages of the life cycle.18 The life cycle is frequently applied to product markets where a product life cycle can be discerned which follows the same stages as the industry life cycle. The product life cycle allows an organization to vary its
marketing mix to produce an appropriate response according to each stage in a product’s development. The industry
life cycle is the supply-side equivalent of the product life cycle.
The industry life cycle helps an organization to see how it is positioned in terms of the development of its markets.
The different stages of the industry life cycle will have an impact upon competitive conditions facing the organization.
For example, one would expect the level of competitive rivalry during the introduction stage, when a market is being
opened up, to be different from that in the maturity stage, when the market is saturated and market share comes at the
expense of your competitors. Therefore, an organization can benefit from an understanding of the industry life cycle
and formulate its strategy to match the needs of each stage more closely.
3.5.1 Introduction Stage
The introduction stage of the industry life cycle (Figure 3.4) is characterized by slow growth in sales and high
costs as a result of limited production. Organizations invest in research and development (R&D) to produce new
products. This commands a premium price and confers upon the organization a first-mover advantage.19 During this stage profits will be negative, as sales are insufficient to cover the capital outlay on R&D. An advantage
of being the first mover is that an organization may set the industry standard even in the face of a superior
­technology.20 Consider the VHS standard set by Matsushita for video recording in the face of a superior product,
Betamax, developed by Sony. However, the tendency is for product life cycles to be compressed, as each stage
is cut short by rapid change, which means that any first-mover advantage is quickly eroded. This also means
that the timescale for a firm to recoup its capital expenditure is shortened, which brings a greater risk for the
first mover.
Industry Life Cycle
Introduction
Sales/
Profits
Growth
Maturity
Unit Sales
Profits
Time
Figure 3.4 Industry life cycle.
Decline
CHAPTER 3 Industry Analysis
71
3.5.2 Growth Stage
In the growth stage, sales increase rapidly as the market grows, allowing firms to reap the benefits of economies
of scale. The increase in product sales brings greater profits, which in turn attracts new entrants to the market. As
consumer awareness of the product grows, so firms vie to have their brands adopted and increase spending on marketing activities. A goal for the firm is not merely to attract new customers, but to ensure that customers repeat their
purchases.
The maturity stage of the life cycle sees a slowing in sales growth and profits as the market becomes saturated. Firms
will begin to exit the industry, and low cost competition based on efficient production and technically proficient processes becomes more important. As market share can only be achieved at the expense of competitors, rivalry becomes
more intense within the industry. With exit barriers, the rivalry will be more intense still as marginal firms find it difficult
to exit the industry. During the maturity stage of the life cycle it is conceivable that a product may benefit from innovation or finding new consumer markets. It may become rejuvenated. For example, Johnson & Johnson have successfully
targeted their baby-oil products at female consumers and thereby created a new market. Somewhat controversially,
the pharmaceutical industry has found that drugs which are deemed unacceptable on health grounds in Western
economies can be marketed to developing nations where regulatory requirements are less stringent.
3.5.4 Decline Stage
In the decline stage firms experience a fall in sales and profitability. Consumer loyalty shifts to new products based on
newer technologies. For example, fewer consumers bother to write cheques, preferring instead to use debit and credit
cards, and mobile payment apps. Streaming video content supercedes renting DVDs. Competition within the industry
will be based on price as consumers shun the old products. Firms will continue to exit the industry and consolidation
may occur as a strategy for firms to achieve acceptable profits. Knowledge of the industry life cycle helps managers
in an organization understand how each stage can affect their competitive environment. In line with their rivals, they
must ensure that their strategy formulation is sufficiently robust to meet the needs of each stage of the cycle.
3.6 Strategic Groups
The analysis so far has been at the level of the entire industry. An industry is a group of firms producing similar products
and services. Economists define an industry as a group of firms that supply a market. A market is a group of customers
who purchase the same products and services. Therefore, in order to ascertain the boundary of an industry we need to
identify the relevant market for the firm.21 This will allow us to see who the competitors in that industry are. We can ask:
are the inputs and product technologies of organizations similar? Is there a significant degree of overlap between the
different products’ customers? To determine the range of products in the market for Lexus cars, we might ask whether
consumers would substitute buying a van instead of a car on the basis of their differences in price. If the answer is
‘no’, we can deduce that cars and vans are in different markets. If customers are willing to substitute among different
makes of automobiles, such as sports cars and luxury models based on their relative price differences, we can say this
constitutes a market. And Lexus occupies this market rather than just the luxury car market.
3
3.5.3 Maturity Stage
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PART TWO Strategic Analysis
3
Also, if manufacturers find it relatively easy to switch their production from luxury cars to high-volume cars, this supply-side substitutability would suggest that Lexus is competing within the broader automobile market. In fact, Toyota, which traditionally competes in the high-volume end of the market, showed that it is also capable of competing
in the luxury market when it introduced its Lexus brand of cars. Toyota’s success in competing in the luxury car market
reminds us that any car manufacturer in that segment, such as BMW or Mercedes, would be unwise to assume their
market was merely other cars in that luxury segment. Rather, they need to be aware of the high degree of supply-side
substitutability that might be achieved between mass market and luxury cars.
In addition to analysis at the industry level, it is also possible to undertake structural analysis within an industry. Just
because organizations are in the same industry does not make them competitors. At first glance this may seem like a
contradiction. For example, how can car manufacturers in the automobile industry not be in competition with each
other? However, a closer analysis of the industry shows that strategic group or clusters of organizations tend to exist.
For Porter, ‘a strategic group is the group of firms in an industry following the same or a similar strategy’.22 Strategic
group analysis is about identifying firms within an industry who possess similar resource capabilities and are pursuing
similar strategies. If we recognize the capabilities and strategies of firms that are most like our organization, we have
a greater understanding of our competitors. Why? Because in any industry an organization’s greatest competitors are
going to be the firms most like it.
Strategic groups within an industry constitute a cluster and inform us that just because competitors occupy the same
industry does not make them competitors. In the US, Ford, General Motors, and Chrysler occupy the same strategic
group within the automobile industry. They are clearly in competition for the same consumers. In the UK, Morgan, a
family-owned car company, and Ford are in the same industry but do not compete with each other. Morgan produce
a limited number of hand-made cars and have a waiting list for their products that is counted in years. Therefore, Ford
and Morgan would occupy different strategic groups. Firms in the same strategic groups tend to have similar market
shares and respond in similar ways to external trends or competitor moves in the industry. Strategic group analysis falls
between analysing each organization individually and looking at the industry as a whole.
3.6.1 Strategic Maps
A strategic map is a useful tool for comparing the strategies of organizations in an industry. An organization selects two
characteristics that can differentiate firms within the industry and draws them on the vertical and horizontal axes. A
starting point might be to look at the most profitable and least profitable firms in the industry, and the characteristics
that separate them. A certain amount of judgement is required when deciding the two-dimensional axes on which
strategic groups are mapped. For example, the two axes might include characteristics such as price, product range,
geographical coverage, reliability, extent of vertical integration, and marketing expenditure. Figure 3.5 represents
a simplified illustration of the world automobile industry. The two characteristics chosen are price and product range
to map the strategic groups.
3.6.2 Mobility Barriers
In the same way that an organization may be prevented from entering an industry by barriers to entry, mobility barriers inhibit movement between strategic groups. Porter defines mobility barriers as ‘factors that deter movement of
firms from one strategic position to another’.23 McGee and Thomas view mobility barriers as, ‘. . . factors which deter or
CHAPTER 3 Industry Analysis
High
73
Rolls-Royce
Bentley
Ferrari
Aston Martin
Porsche
Price
Ford
Honda
General Motors
VW
Nissan
Toyota
Low
Low
Product range
High
Figure 3.5 A map of strategic groups within the world automobile industry.
inhibit movement of a firm from one strategic position to another. Therefore a mobility barrier is essentially a limitation
on replicability or imitation.’24 For example, if barriers which derive from economies of scale exist, they will be more
likely to protect a strategic group which includes organizations that have large plants. If the factors that prevent mobility result from an organization’s strategy, it simply increases the cost to other organizations of adopting that strategy.
Porter suggests that organizations in strategic groups with high mobility barriers will achieve greater profits than
those in groups with lower mobility barriers. However, there is conflicting evidence on this point.25 The changing trends
within an industry may point to the existence of viable strategic space between groups which could be exploited by an
organization that possesses the requisite assets.
In Figure 3.5 we see a representation of the world automobile industry with its strategic groups. At the luxury end of
the market are cars such as Rolls-Royce and Bentley, with limited product ranges and high prices; such cars are often
bought as status symbols. The strategic group with Mercedes, BMW, and Lexus produce a lower product range but at
a higher quality and price than the volume manufacturers which comprise the group occupied by Ford and Renault.
There has been movement in the industry as manufacturers such as BMW and Audi introduced lower priced, compact saloons to draw customers away from volume manufacturers. This strategy carries a risk of alienating customers
loyal to the brand who may perceive it as being denigrated. BMW and Porsche introduced sports utility vehicles in an
attempt to capture a share of the lucrative sport utility vehicle (SUV) market.
In undertaking strategic group analysis, an organization can better understand its industry structure. By mapping
rivals following similar strategies into strategic groups, an organization can ascertain their most direct competitors.
By understanding competitor capabilities, an organization can assess the viability of mobility barriers in preventing
competitors gaining market share. And, by forecasting the impact of industry trends, an organization is better able to
assess the sustainability of strategic groups and the viability of strategic space. That said, there are critics who question
the existence of strategic groups and whether studying intra-industry groups provides information that cannot be
acquired by looking at industries and individual firms.26
3
BMW
Mercedes
Lexus
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PART TWO Strategic Analysis
3
Strategic group analysis enables an organization to better understand competitive positions in its industry. By mapping rivals following similar strategies into strategic groups, an organization can:
●
Identify who their direct competitors are and the extent of competitive rivalry within their strategic group
●
Identify the viability of mobility barriers which prevent organizations moving from one strategic group to
another
●
Track the direction in which competitor organizations are moving. By drawing arrows from each strategic group
to show in which direction the groups may be moving it becomes possible to assess the extent of structural
changes. For instance, if strategic groups are moving farther apart, this may mean that strategic ‘spaces’ exist
which can be exploited without increasing competition. If groups are converging, this implies greater volatility.
Taken together, these changes may help an organization predict a change in industry evolution.
For more information on strategic groups, go to the online resources and see the Extension Material
for this chapter.
www.oup.com/uk/henry3e/
3.7 Hypercompetition and Disruptive Innovation
3.7.1 Hypercompetition
The term ‘hypercompetition’ was introduced by Richard D’Aveni to explain a relentless mode of competitive behaviour
that aims to force competitors out of the industry. Hypercompetition is defined as, ‘an environment characterized by
intense and rapid competitive moves, in which competitors must move quickly to build advantage and erode the
advantage of their rivals’.27 This fierce competition is often seen in the video games and software industry. For example, Apples’s closed systems prevent competitors gaining access to their software code. Their huge financial reserves
have allowed them to compete aggressively by buying up potential threats while they are still emerging companies.
More important, Apples’s constant upgrading of new product offerings has the effect of destabilizing the consumer
electronics industry and forcing competitors to react. D’Aveni argues that organizations can no longer build a sustainable competitive advantage as this advantage is eventually eroded. In fact, he argues that organizations must consciously disrupt their own competitive advantages as well as the advantages of competitors.
Hypercompetition is characterized by competitors creating constant disequilibrium, which causes the industry to
‘escalate towards higher and higher levels of uncertainty, dynamisms, heterogeneity of players, and hostility’.28 The
driving force of competition is the pursuit of profit, which is obtained by achieving competitive advantage. However,
competitive advantage will only be transitory as rival organizations look for ways to undermine it or make it obsolete.
Therefore, under conditions of hypercompetition managers must continually recreate their competitive advantage if
they are to gain market dominance.29
There is empirical support that managers do not respond to a hypercompetitive environment with a single sustainable
competitive advantage. Instead, they create multiple short-term advantages, which are concatenated into competitive advantage over time. This also supports the view that hypercompetition is widespread among firms rather than
CHAPTER 3 Industry Analysis
75
We saw in Porter’s five forces framework that where an organization incurs huge fixed costs in setting up a plant,
competition for market share will be intense. Networks of consumers and the rapid rate of technological change
exacerbate the effects of extreme-scale economies. Networks of consumers simply means that unless others are
using the same technology our use of that technology becomes redundant. This forces convergence around a single
technical standard such as Microsoft Windows. At the same time, the rate of technological change continues to
accelerate as organizations such as Intel continually shorten the lifespan of technologies and products; this further
intensifies competition. Taken together, these factors produce intense competition, particularly in emerging markets
for new technologies. They create high-stakes industries where the successful competitor has the opportunity for
complete domination. See Strategy in Focus 3.2, which illustrates the requirement for Apple to continually develop
successful products.
STRATEGY IN FOCUS 3.2 Apple’s Hypercompetitive
Market
‘OUR product pipeline has amazing innovations in store’, Tim Cook, CEO of Apple, declared. He hoped to sound
reassuring after the company reported its first year-on-year quarterly revenue decline since 2003. But he was
not convincing enough. Shares of Apple fell by around eight per cent after another set of quarterly results
emerged in 2016, erasing more than $46 billion in market value.
The investors’ immediate concern is the popularity of the iPhone. It accounts for the bulk of Apple’s revenues
and profits; yet sales were eighteen per cent lower than a year ago. The broader smartphone market is sluggish,
says Mr Cook. The bigger question that Mr Cook
must answer is whether Apple will ever have
another product as successful as the iPhone,
the most lucrative in the technology business
to date. Enthusiasm has waned for some of
its other older products, such as iPads, and its
newer ones remain a niche offering.
The Apple Watch celebrated its first full year
on the market in 2016. It sold more in its first
year than the iPhone did in 2007. But today’s
consumers are better primed to buy gadgets
now than they were then; watch sales should be
The Apple Watch looks good, but is it worth the cost? Source: © Anna
far higher. The cost of the Apple Watch, which Hoychuk/Shutterstock
starts at $300 (£232), puts people off, as does
its dependence on a smartphone for most activities, such as providing directions. One bright spot is Apple’s
services business, which is expected to grow steadily. As it sells more gadgets, over one billion devices are in use,
it can also sell content and services, and gain revenue from music, its app store, and more. In the second quarter,
Apple had $6 billion in services revenues, more than for Macs or iPads.
3
being limited to high-technology industries.30 Clayton Christensen argues that the existence of competitive advantage
will set in motion creative innovations that cause the advantage to be eroded as competitors try to catch up.31 For Christensen, the pursuit of competitive advantage is not futile, but the real issue for strategists is to understand the processes
of competition and how competitive advantage comes about.
76
PART TWO Strategic Analysis
3
What else could the firm come up with? That Apple has been working on an electric car is one of the worstkept secrets in the technology business. Reported disagreements with German car makers over control of users’
data may have halted a potential alliance. Many also expected Apple to disrupt television. But Apple TV, the
firm’s alternative to a set-top box and subscription, sells most of its shows and films individually, which becomes
expensive very quickly. Its appeal is limited.
The problem is that it will be difficult for Apple to come up with another single product as central to daily
routines as the iPhone. Collections of devices in connected homes will matter more instead. Apple’s biggest
problem is its past success. It is the most valuable company in the world by market capitalization because
investors believe the firm can make new technologies popular. Mr Cook, who took over as chief executive in
2011, soon before the death of the firm’s co-founder, Steve Jobs, has led Apple competently. But there are
lingering doubts about whether he can produce the sort of smash product for which Jobs was so feted.
Source: ‘The world’s most valuable company needs another mega hit’, The Economist, 30 April 2016. Reproduced with permission.
In hypercompetitive industries such as consumer electronics, competitive advantage requires an organization to risk a
current advantage for the promise of a new advantage. Organizations aggressively position themselves against each
other to create new competitive advantages which make opponents’ advantages obsolete. At best, only a temporary
competitive advantage can be achieved until your competitors catch up or outmanoeuvre your last competitive move.
In effect, hypercompetition requires an organization to replace successful products before its competitors do and
thereby sustain market dominance by constantly recreating its competitive advantage.
3.7.2 Disruptive Innovation
Clayton Christensen’s32 work on disruptive innovation, first introduced in 1995, has resonance with Richard D’Aveni’s
insights. Christensen uses the term ‘disruption’ to describe a process in which a smaller company with fewer resources can
successfully challenge established incumbent businesses.33 It is able to do this because incumbent businesses are focused
on improving products for their most demanding customers at the high-end of the market, which provides them with the
greatest profit. In so doing, incumbents exceed the needs of many mainstream customer segments whilst ignoring less
profitable consumer segments. This provides an opportunity for entrants to target these neglected segments by offering
them products with more suitable functionality, invariably at a lower price. Entrants thereby gain a foothold in the market.
Incumbent firms, focused on the pursuit of higher profits in the more demanding segments, will invariably not
respond strenuously to the loss of a less profitable segment. Over time, entrants start to move upmarket and improve
the quality and performance of their product offerings to attract the incumbents’ mainstream customers. They do
this because moving upmarket also provides them with greater profitability. However, without the improvement in
quality to match the standards of mainstream customers they simply will not accept the entrants’ products, even at
low price. Once the quality rises enough to satisfy them, they gladly adopt the new product with its lower price. When
mainstream customers start adopting the entrants’ offerings in volume, Clayton argues that disruption has occurred.
Larry Downs and Paul Nunes34 argue that the strategic model of disruptive innovation has a blind spot. We have
seen that disrupters offer cheap substitutes to incumbents’ products and capture low-end customers before moving
upmarket to capture higher value customers. However, as they point out, the disruption described by Christensen
allows incumbent businesses some time to develop their own new products as they see their market being eroded. But
CHAPTER 3 Industry Analysis
77
what happens when the disruption does not come from competitors within the same industry or organizations with
vaguely similar business models? What if organizations do not enter at the bottom of a mature market and continue
to more through profitable segments?
3
For example, consider the fate of in-car satellite navigation product makers such as TomTom and Garmin. What devastated TomTom and Garmin’s market was the ubiquitous use of smartphones with free navigation apps, preloaded
on every smartphone. Eighteen months after the debut of navigation apps, leading global positioning system (GPS)
manufacturers had lost eighty-five per cent of their market value. Mobile phone manufacturers were not seeking to
compete with GPS manufacturers, the latter were simply collateral damage. Downes and Nunes use the term ‘big bang
disruption’ to capture a change in industry dynamics in which not only the least profitable customers are lured away,
but consumers in every segment defect simultaneously.
To understand industry dynamics, incumbent businesses now need to be aware that the industry life cycle, alluded to
earlier in the chapter, effectively becomes concertinaed. In addition, the traditional bell shape of the industry life cycle
curve now more resembles a shark’s fin, with an almost vertical rise and corresponding steep fall. And all this occurs
within a much shorter period of time. The question thus arises: how can incumbent organizations survive such big
bang disruptions? We look at this question in Chapter 7, within the context of strategy formulation.
Summary
It is clear that the business environment has a more direct impact on an organization’s performance. Porter’s five
forces framework enables an incumbent organization to assess the attractiveness of its industry based on the relative
strength of the five forces. An organization should position itself against, and seek to influence, the five forces. According to critics, a major limitation of the five forces framework is its static nature; a charge contested by Porter.
Brandenburger and Nalebuff introduce the concept of the value net in the business environment. The value net represents
a map of the industry, the customers, suppliers, and competitors in the industry, and their relationship to each other. They
also introduce the role of complementor. The five forces can be extended by adding complementors as an additional force.
A strategic group is a cluster of firms in an industry following the same or a similar strategy. A strategic map is useful for
identifying mobility barriers which prevent organizations moving from one strategic group to another. By analysing
the effects of industry trends on strategic groups, it may help organizations to predict a change in industry dynamics.
In hypercompetitive environments organizations must consciously disrupt their own competitive advantages as well
as those of opponents. Competitive advantage is seen as temporary, and lasts only as long as it takes for competitors
to catch up or outmanoeuvre your last competitive move. Hypercompetition is characterized by intense and rapid
competitive moves. It is more likely to be seen in industries characterized by rapid technology innovation.
Disruptive innovation occurs when an incumbent organization focuses on its most profitable upmarket segment leaving an entrant free to nibble away at its low-end customers, unchallenged. The entrant gradually moves upmarket to
acquire the incumbent’s higher-end customers. With big bang disruptions, the disruption of consumers is fast and
total, leaving the incumbent little or no time to react.
78
PART TWO Strategic Analysis
CASE EXAMPLE Ryanair: How to Compete in the Airline
Industry
3
Background
It may surprise many people to know that
­Ryanair is Europe’s favourite airline. The ­low cost
airline carries 120 million passengers every year
on more than 1,800 daily flights. It flies from
eighty-six bases, connecting over 200 destinations, in thirty-four countries. It has more than
12,000 employees and an industry-leading Europe’s favourite airline. Source: Courtesy of Ryanair
thirty-two-year safety record. Ryanair was
founded in Ireland in 1985, initially operating daily from Waterford in the southeast of Ireland to London Gatwick. By 1990 the airline had accumulated £20 million in losses and went through a process of restructuring. As
part of this restructuring, a new CEO, Michael O’Leary, was hired and dispatched to the US to understand what
makes low cost Southwest Airlines so successful. The intention was to copy Southwest Airlines’ US business
model and adapt it for use in Europe. In 1991, despite the Gulf War, Ryanair made a profit for the first time.
Southwest Airlines
Southwest Airlines is the world’s first successful low cost airline. It pioneered a model for reducing operating
costs which is now used all over the world. To reduce costs Southwest fills its planes with more seats, makes
sure each flight is packed, and flies its aircraft more often than full-service airlines. In addition, it only purchases
one type of aircraft, Boeing 737-800s. The advantage of this is that they only need to train mechanics to service
one type of airplane. Supply parts and inventory for aircraft maintenance are streamlined. If they have to take a
plane out of service at the last minute for maintenance, the fleet is totally interchangeable; both on-board crews
and ground crews are already familiar with it. And it faces few challenges in how and where it can park its planes
on the ground, since they’re all the same shape and size.
Moreover, Southwest does not assign seat numbers. This means that if one plane is substituted for another,
and the new plane has a different seat configuration, there’s no need to adjust the entire seating arrangement
and issue new boarding passes. Passengers simply board and sit where they like. To lure customers from other
airlines, Southwest Airlines does not charge for the first and second checked baggage. It also recognizes that
consumers have different travel needs; some are content to book weeks in advance, while others have a need
for more immediate flights. The use of yield-management systems allows Southwest to raise ticket prices when
demand is high and reduce them during quiet periods, which also increases efficiency. Its flights are usually
point-to-point; that is, the plane lands, is turned around, and often heads back to where it came from.
How Ryanair Competes
Michael O’Leary was to take careful note of Southwest Airline’s low cost structure and how it competes in the
airline industry. However, Mr O’Leary is a pragmatist and understood that Southwest’s business model would
not work in the regulated European airline industry. In 1997, the so-called ‘Open Skies’ policy of the European
Union was implemented, which effectively deregulated the scheduled airline business in Europe. This enables
airlines to compete freely throughout Europe. At the same time, Ryanair became a public limited company,
offering its shares on the Dublin and New York (NASDAQ) Stock Exchange. This provided further capital for the
purchase of aircraft.
Since deregulation, Mr O’Leary has taken the no-frills concept pioneered by Southwest Airlines and substantially extended it. The airline is not known for its glamorous waiting-rooms, nor for having an empathetic customer service. Under Mr O’Leary’s leadership, Ryanair has used punitive fees to manage passenger behaviour
more than other airlines. For example, to reduce ground-staff numbers, it is now prohibitively expensive to
check in at the airport or to store luggage in the hold when travelling with Ryanair. When it flies to a city, it utilizes that city’s secondary and even tertiary airports, where the costs of operating are cheaper than flying to the
main airport. As a result, there’s less delay in turning around the aircraft to get it back in the sky. The airline has
often made provocative announcements; for example, it made headlines with a suggestion that it might charge
passengers to use aircraft toilets. No doubt, it believes that ‘all publicity is good publicity’, since such outbursts
keep its advertising budget to a minimum.
In common with Southwest Airlines, Ryanair flies only Boeing 737-800s. In 2006, it flew 42.5 million passengers
in the year and took delivery of its hundredth Boeing 737-800. It also launched its Web check-in service, giving
passengers the opportunity to check-in online. In order to generate further revenue, Ryanair introduced onboard mobile phone use across its entire fleet which lets customers gamble and play bingo during the flight. The
year before, to celebrate its twentieth anniversary, it offered 100,000 flights at only ninety-nine pence each. At the
same time, it reminded passengers that its competitors add a fuel surcharge to top up the price of their tickets.
Growth in passenger numbers continue as it strips out non-essential services and introduces yield-management systems which allow it to vary ticket prices according to demand. For Ryanair’s CEO, pricing is not complex;
it is all about what the market will bear. In 2010, traffic grew to 72.1 million passengers with an average fare of
only €39 and no fuel surcharges, despite a sharp increase in fuel costs. Their business model is ‘load factor-active,
yield-passive’. Ryanair takes whatever ticket prices it can get in order to ensure the aircraft is as full as possible;
in other words, it achieves a high load factor.
In the past, Mr O’Leary has suggested a load factor of between eighty-two and eighty-three per cent throughout the year would be fine; Ryanair’s actual load factor is often in access of ninety per cent. What this allows it
to do is to capitalize on the prevailing low-fare trend. It creates a virtuous cycle in which low fares encourage
greater passenger traffic. As more passengers fly, so this continues to drive both the cost reduction it achieves
from using airports, and lowers its unit cost per employee and per aircraft. Crucially, high passenger numbers
also drive the demand for ancillary services. It actively supports its load factor by offering a range of lower fares
and aggressive seat sales. By 2015, traffic passed the 100 million customer mark; 106.4 million customers are
flown, at an average fare of €46 and a 93 per cent load factor.
Customer Service
In 2013, Ryanair was considered to have the worst customer service out of Britain’s 100 biggest brands in a
survey by a consumer magazine. In the same year, two quarterly profit warnings showed Ryanair failing to
keep up with its rivals, including easyJet, whose friendlier image had attracted flyers. The usually belligerent
Mr O’Leary was forced to make a conscious effort to improve Ryanair’s corporate reputation and avoid losing
sales to competitors. In a bid to show how Ryanair is undergoing ‘revolutionary’ customer change, the boss of
Europe’s biggest low cost airline was presented to the world cuddling a puppy. The chief executive, revealed his
new image at an event to launch the airline’s new, updated website and app. Mr O’Leary said the airline had an
‘Always Getting Better’ plan, starting with ‘fixing the things our customers don’t like’.
79
3
CHAPTER 3 Industry Analysis
3
80
PART TWO Strategic Analysis
By 2014 it had relaxed its hard-line cabin baggage allowance, reduced penalties for failing to print out boarding
passes, and introduced allocated seating. For example,
an unpopular €70 fee for re-issuing boarding passes at
the airport was lowered to €10. Mr O’Leary also promised
that flyers will no longer pay disproportionate charges
for small transgressions in hand-luggage size: he blamed
local agents in some airports for applying his rules with
excess zeal. ‘There’s no more conflict’, he said. The new
website drastically reduces the number of steps required
to book a flight, and allows regular travellers to store
information about their travel documents and payment
card. The moves were a response to easyJet filling its
planes more successfully than any other European airline
and making healthy profits. To placate customers, Ryanair also followed its arch-rival into primary hubs such as
Rome Fiumicino and Brussels, and began moving away
from ‘secondary’ airports. The effect of this ‘nicer guy’
approach was a leap in profits to €867m.
Michael O’Leary, CEO of Ryanair. Source: Courtesy of Ryanair
Lowest Cost Competitor
Ryanair has always been efficient at making money from its ancillary services. In 2016 ancillary services
accounted for twenty-seven per cent of its revenue. For example, consumers can expect to pay for everything
else after paying for their flight. This includes seat reservations, booking hotels through Ryanair’s website,
snacks on the plane, water to drink; just about everything comes at a cost. This constant cost cutting has allowed
Ryanair to make a profit even when consumer demand falls. Customers keep coming back, not least because
the cost reductions are passed on to them in the form of lower fares (Figure 3.6).
The threat of substitutes refers to products and services which can meet similar needs. Therefore, the question becomes: if one chooses not to fly with the low cost airline industry, what alternatives are available? Here
the price–performance ratio comes into play. The more attractive the price–performance ratio of substitute
products, the greater is the restraint on an industry’s profits. Therefore, the price–performance ratio of the low
cost airline industry vis-à-vis their substitutes will determine profitability levels within the industry. Given Ryanair’s low fares, and the convenience and speed of flying to one’s destination, can ferry, train, or coach substitutes offer a viable alternative?
Other full-service airlines such as Air France and Lufthansa have struggled to cut their wage costs to compete.
British Airways, which is part of the International Airlines Group, has tried to copy Ryanair by squeezing extra
seats onto their planes and selling supermarket sandwiches on board to generate extra revenue. However,
unlike Ryanair, British Airways has always been concerned to protect its brand image. That said, Ryanair became
Europe’s favourite airline in 2016 in terms of the number of passengers it carries, taking the mantle from Germany’s Lufthansa.
Aircraft are the single largest capital cost in any airline, so getting fleet costs right is a key objective. In 2013,
Ryanair acquired 180 new Boeing 737-800s with a list price of $15 billion. This was negotiated at a time when
Boeing was launching its all-new Boeing 737 MAX aircraft with extra seats. With this deal Ryanair had the
CHAPTER 3 Industry Analysis
81
140
100
80
60
40
3
Passenger numbers (millions)
120
20
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Year
Figure 3.6 Ryanair passenger numbers (in millions) from 2000 to 2016. Source: Data from Ryanair.com
capacity to grow the fleet by fifty per cent without compromising on flight cost per passenger. It since expanded
that order even further to add 110 units of the 737 MAX aircraft, with options on another 100. These planes provide extra seats and new, efficient engines that will cut unit costs even more and further improve the carrier’s
competitiveness. Ryanair is a massive customer for Boeing, which allows it to negotiate the best prices for its
fleet of aircraft. Also, aircraft manufacture is dominated by two players, Boeing and Airbus, and Ryanair has said
in the past that it will buy from Airbus if it doesn’t receive the deal it needs from Boeing. Another major cost, the
cost of fuel, is determined by the price of oil, and falling oil prices benefit all airlines.
Mr O’Leary is all too aware that, given Ryanair’s low cost base, it can still make profits even when its ticket prices
are cheaper than any of its rivals. He predicts that as fares continue to fall, his airline will fly over 200 million passengers a year by 2024. In 2017, the Irish airline made a profit after tax of €1.3bn (£1.1bn), even though it slashed
ticket prices. Michael O’Leary said fares had fallen by thirteen per cent, but profitability has doubled over three
years. He added, ‘Frankly I see no reason why that trend won’t continue.’
Questions
1. Conduct a five forces analysis to determine how attractive the low cost airline industry is. You might
label each competitive force as high, medium, or low, depending on their relative strength and potential
impact on Ryanair’s profitability.
2. Why haven’t other airlines imitated Ryanair’s success?
Sources: Seth Stevenson, ‘The Southwest secret—how the airline manages to turn a profit, year after year’, Slate, 12 June 2012; ‘Why are no-frills airlines so
cheap’, The Economist, 18 October 2013; ‘Oh really, O’Leary’, The Economist, 19 October 2013; Simon Calder, ‘Michael O’Leary launches Ryanair’s “always getting
better” plan’, The Independent, 26 March 2014; ‘Ryanair close to paying $10 billion Boeing order’, reuter.co.uk, 5 September 2014; ‘Ryanair wants to control
even more of Europe’s aviation market’, The Economist, 7 November 2016; Joe Gill, ‘Nice and profitable: how Ryanair revamped itself’, The Irish Times, 21 May
2016; Stuart Jeffries, ‘Nice is more than a destination: what Ryanair can teach United Airlines’, The Guardian, 11 April 2017; ‘Ryanair makes £1.1bn pound profit
despite cutting fares’ The Guardian, 13 May 2017; ‘Ryanair: restricted leg room’, Financial Times, 30 May 2017.
82
PART TWO Strategic Analysis
Review Questions
1. Explain how the industry life cycle helps an organization understand the changes taking place in its industry.
2. What does hypercompetition teach us about the pursuit of sustainable competitive advantage?
Discussion Question
3
The effect of government policy on industry structure is too pervasive to consider government as a sixth competitive force. Discuss.
Research Topic
Use strategic groups to analyse the newspaper industry, paying particular attention to what mobility barriers exist,
and the trends that are changing this industry.
Recommended Reading
For a discussion of the five forces framework and strategic groups see:
●
M. E. Porter, Competitive Strategy: Techniques for Analysing Industries and Competitors, Free Press, 1980.
For an insight into the need for organizations to cooperate as well as compete with players in their competitive
environment, see:
●
A. Brandenburger and B. J. Nalebuff, Co-opetition, Currency Doubleday, 1996.
An informative read on the use of game theory for strategy formulation is:
●
A. Brandenburger and B. J. Nalebuff, ‘The right game: use game theory to shape strategy’, Harvard Business
Review, vol. 73, no. 4 (1995), pp. 57–71.
For a discussion of hypercompetition, see:
●
R. A. D’Aveni, Hypercompetition: Managing the Dynamics of Strategic Manoeuvring, Free Press, 1994.
www.oup.com/uk/henry3e/
Visit the online resources that accompany this book for activities and more information on industry analysis.
References and Notes
1
See M. E. Porter, Competitive Strategy: Techniques for Analysing Industries and Competitors, Free Press, 1980.
2
For a discussion of the background to Porter’s five forces, see Argyres and McGahan, ‘An interview with
Michael Porter’, Academy of Management Executive, vol. 16, no. 2 (2002), pp. 43–52.
3
For a more recent discussion, see M. E. Porter, ‘The five forces that shape strategy’, Harvard Business Review,
vol. 86, no. 1 (2008), pp. 78–93.
4
For a discussion of the structural analysis of industries, see Porter, n. 1.
5
See Porter, n. 1, chapter 1, for a full discussion of cost advantages independent of size.
6
See Porter, n. 1, chapter 2, for a discussion of strategy formulation.
7
For an introduction to the role of complements, see A. Brandenburger and B. J. Nalebuff, ‘The right game:
use game theory to shape strategy’, Harvard Business Review, vol. 73, no. 4 (1995), pp. 57–71.
8
For a discussion of the static nature of Porter’s five forces, see C. K. Prahalad, ‘Changes in the competitive
battlefield’, in Mastering Strategy, edited by T. Dickson, Prentice Hall, 2000, pp. 75–80.
9
For an insight into how industry players with relatively few resources but big ambitions can take on industry
giants and win, see G. Hamel and C. K. Prahalad, ‘Strategy as stretch and leverage’, Harvard Business Review,
no. 71, vol. 2 (1993), pp. 75–84; and G. Hamel and C. K. Prahalad, Competing for the Future, Harvard Business
School Press, 1994.
10
H. Mintzberg and J. A. Waters, ‘Of strategies deliberate and emergent’, Strategic Management Journal, vol. 6,
no. 3 (1985), pp. 257–72.
11
A. Brandenburger and B. J. Nalebuff, Co-opetition, Currency Doubleday, 1996.
12
For a more detailed discussion of Porter’s response to his critics, see N. Argyres and A. M. McGahan, ‘An
interview with Michael Porter’, Academy of Management Executive, vol. 16, no. 2 (2002), pp. 43–52.
13
For a wider discussion of Michael Porter’s ideas on strategy, see M. E. Porter, ‘What is strategy?’, Harvard
Business Review, vol. 74, no. 6 (1996), pp 61–78.
14
See Brandenburger and Nalebuff, n. 11.
15
See Brandenburger and Nalebuff, n. 11.
16
A. Brandenburger and B. J. Nalebuff, ‘Co-opetition: competitive and cooperative business strategies for the
digital economy’, Strategy and Leadership, vol. 25, no. 6 (1997), pp. 28–33.
17
Brandenburger and Nalebuff, n. 16.
18
See A. McGahan, ‘How industries evolve’, Business Strategy Review, vol. 11, no. 3 (2000), pp. 1–16.
19
M. B. Lieberman and D. G. Montgomery, ‘First mover advantages’, Strategic Management Journal, vol. 9, no.
5 (1988), pp. 41–58.
20
C. Shapiro and H. R. Varian, ‘Standard wars’, California Management Review, vol. 41, no. 2 (1999), pp. 8–32.
21
For a discussion of industry boundaries, see R. M. Grant, Contemporary Strategy Analysis, Blackwell, 2005.
22
See Porter, n. 1, p. 29.
23
Porter, n. 1, p. 135.
24
J. McGee and H. Thomas, ‘Strategic groups: theory, research and taxonomy’, Strategic Management Journal,
vol. 7, no. 2 (1986), p. 153.
25
See Grant, n. 21, chapter 4.
26
D. Dranove, M. Peteraf, and M. Shanley, ‘Do strategic groups exist? An economic framework of analysis’,
Strategic Management Journal, vol. 19, no. 11 (1998), pp. 1029–44.
27
R. A. D’Aveni, Hypercompetition: Managing the Dynamics of Strategic Manoeuvring, Free Press, 1994,
pp. 217–18.
83
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CHAPTER 3 Industry Analysis
PART TWO Strategic Analysis
28
R. A. D’Aveni, ‘Coping with hypercompetition: utilising the new 7S’s framework’, Academy of Management
Executive, vol. 9, no. 3 (1995), p. 46.
29
See R. A. D’Aveni, G. B. Dagnino, and K. G. Smith, ‘The Age of temporary advantage’, Strategic Management
Journal, vol. 31, no. 13 (2010), pp. 1371–85 for speculation on what strategic management would look like if
sustainable advantages did not exist.
30
R. R. Wiggins and T. Ruefli, ‘Schumpeter’s ghost: is hypercompetition making the best of times shorter?’,
Strategic Management Journal, vol. 26, no. 10 (2005), pp. 887–911.
31
C. M. Christensen, ‘The past and future of competitive advantage’, Sloan Management Review, vol. 42, no. 2
(2001), pp. 105–9.
32
J. Bower and C. M. Christensen, ‘Disruptive technologies: catching the wave’, Harvard Business Review, vol.
73, no. 1 (1995), pp. 43–53.
33
For a discussion of disruptive innovation and the misunderstandings surrounding its use, see C. M.
Christensen, M. E. Raynor, and R. McDonald, ‘What is disruptive innovation?’, Harvard Business Review, vol.
93, no. 12 (2015), pp. 44–53.
34
L. Downs and P. Nunes, ‘Big bang disruption: a new kind of innovator can wipe out incumbents in a flash’,
Harvard Business Review, vol. 91, no. 3 (2013), pp. 44–56.
3
84
CHAPTER 4
THE INTERNAL ENVIRONMENT:
VALUE-CREATING ACTIVITIES
4.1 Background to
Differential Firm Performance
Extension Material
Differential firm
performance
4.5 Organizational
Performance
4.3 Evaluating the
Value Chain
4.2 Value Chain
Analysis
Main Reference
Porter, M.E. (1985).
Competitive Advantage.
Free Press, New York.
4.4 SWOT Analysis
Working through
Strategy
Undertaking
a SWOT analysis
4.6 A Balanced Scorecard
R. S. Kaplan and
D. P. Norton,
‘The balanced
scorecard—measures that
drive performance’, Harvard
Business Review, vol. 69,
no. 1 (1992), pp. 71–9.
Learning Objectives
After completing this chapter you should be able to:
●
●
●
●
●
●
4.7 Benchmarking
Discuss the determinants of an organization’s performance
Understand the activities which comprise an organization’s value chain and
identify their role in adding value
Explain how linkages in the value chain can create competitive advantage
Undertake a SWOT analysis and discuss its limitations
Evaluate the ways in which the performance of an organization can be measured
Identify the benefits which derive from benchmarking
86
PART TWO Strategic Analysis
Introduction
In this chapter, we turn our attention to how an organization can analyse its value-creating activities. In addition,
we also consider how a firm assesses its performance. It is important to realize that, as with strategy formulation,
a debate exists about what constitutes differential firm performance. Differential firm performance refers to the
observation that organizations which possess similar resources and operate within the same industry experience
different levels of profitability. A common criticism made about industry analysis is that it fails to adequately answer
this question. Indeed, many contributors within the field of strategic management would argue that a focus on
industry analysis has diverted attention away from this question. The views of these individuals are discussed in
detail in Chapter 5.
4
4.1 Background to Differential Firm Performance
Since Michael Porter’s seminal work on industry and competitor analysis,1 a debate continues about what drives an
organization’s performance. Is the industry context in which the organization finds itself the main determinant of its
performance? Or, are there factors contained within each individual organization which may more readily account for
how well that organization performs?2 Put another way, in devising strategy, should a company’s main focus be the
characteristics of its industry or the characteristics of its own organization?
For Porter,3 as we saw in our discussion of the competitive environment, industry characteristics are paramount. His
approach is often referred to as the ‘positioning’ school. That is, the organization is viewed as capable of adopting a
strategy which allows it to position itself within the industry to take advantage of the prevailing industry structure.
Thus, for Porter, the attractiveness or profitability of an industry is determined by his five forces framework. As we see
when we come to look at strategy formulation in Chapter 7, if we adopt this view the corollary is that an organization
is faced with a limited number of strategies on which to compete.
Richard Rumelt4 argues that, contrary to the assertions of the positioning school, the defining factor in differential firm
performance is not the industry structure in which the organization finds itself. Rather, it is more to do with factors at the
individual firm level such as its resources and the strategy being adopted. This is contested by Hawawini et al.5 (2003),
who suggest the organization’s external environment or industry effects are more important than firm-specific factors.
If Rumelt is correct, it has implications for exactly what the organization should be focusing its strategic attention on and
provides a broader arena for strategy formulation. Therefore, it is not surprising to find that strategic management as a
discipline has become increasingly concerned with the internal environment of the organization. This approach is characterized by the resource-based view of strategy associated with the work of C. K. Prahalad, Gary Hamel, and Robert Grant6 ,
which we consider in Chapter 5.
For more information on differential firm performance, visit the online resources and see the
Extension Material for this chapter.
www.oup.com/uk/henry3e/
CHAPTER 4 The Internal Environment: Value-Creating Activities
87
4.2 Value Chain Analysis
If we want to increase the value an organization adds for the consumers of its products, we need to know where this
occurs and how much value each activity adds. We need to know how an organization might enhance this value added
further by reconfiguring parts (or all) of the value-added process. However, it is increasingly recognized that organizations can also add value through cooperation with their suppliers, customers, and distributors. This process is referred
to as the value chain system and recognizes that an organization’s own value chain will interact with the value chain
prevalent in other organizations.
For example, a supplier’s value chain, referred to as upstream value, will influence an organization’s performance.
Similarly, an organization’s product will ultimately become part of a buyer’s value chain, providing downstream
value. How an organization manages the linkages between itself and other organizations will have an impact
on how value is created within the supply chain system. If this is done carefully it can result in a non-zero-sum
game in which all parties within the supply chain system benefit and provide the organization with competitive
advantage.
Competitive advantage may derive from specific activities within the organization and how these activities relate
to each other, and to supplier and customer activities. Where competitive advantage is a result of the configuration
of many different activities, clearly it will be more difficult to imitate and therefore more sustainable. Strategy then
can be seen to be about how an organization configures its range of activities vis-à-vis its competitors. Therefore, if
an organization wishes to pursue a low cost strategy, this implies that it engages in a particular configuration of its
activities. If an organization wishes to pursue a differentiation strategy, it would need a different configuration of
its value- chain activities. A discussion of strategy formulation for an organization is covered in detail in Chapter 7.
4.2.1 Primary Activities
We can see that an organization is a collection of activities which aid it in the design, production, marketing, and
support of its product.9 All these activities can be captured using value chain analysis. In assessing an organization’s
activities it is important to analyse these at the level of the strategic business unit (SBU). The activities contained within
the value chain are classified by Porter as primary activities and support activities10 (see Figure 4.1). Primary activities are activities which are directly involved in the creation of a product or service. Support activities are activities
which ensure that the primary activities are carried out efficiently and effectively. These primary and support activities
provide the link between an organization’s strategy and its implementation. This is because once the organization is
4
Value Chain analysis looks at the activities that go to make up a product or service with a view to ascertaining
how much value each activity adds. It was devised by Porter as a technique to help an organization assess its internal resources.7The value or margin of a product is calculated by the amount of revenue it earns, in this case total
revenue, which is calculated by the price of the product (or service) multiplied by the quantity consumed. If we know
the total cost of each product, then the difference between the total revenue and total cost is the profit margin for
the organization. Thus, the greater the difference between the organization’s revenue and its costs, the greater the
value it is adding.8
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FIRM INFRASTRUCTURE
IN
RG
MA
HUMAN RESOURCE MANAGEMENT
SUPPORT
ACTIVITIES
TECHNOLOGY DEVELOPMENT
PROCUREMENT
OPERATIONS
OUTBOUND
LOGISTICS
MARKETING
& SALES
SERVICE
MA
RG
IN
INBOUND
LOGISTICS
PRIMARY ACTIVITIES
4
Figure 4.1 The value chain. Source: Modified with permission of The Free Press, a Division of Simon & Schuster Inc., from Michael E. Porter, Competitive Advantage:
Creating and Sustaining Superior Performance, Free Press. Copyright © 1985, 1988 by The Free Press. All rights reserved.
seen as a collection of activities, and every employee is involved in an activity, it becomes apparent that everyone has
a role to play in strategy implementation. Therefore, it becomes crucial that an organization’s strategy is clearly communicated throughout the organization so that individuals understand why they are involved in particular activities,
and how this relates to other activities.
Primary activities are those activities which are directly involved in the creation and sale of a product or service. They
include the following five generic categories: inbound logistics, operations, outbound logistics, marketing and sales, and
service. These are explained in Table 4.1. Each primary activity can be subdivided into a number of distinct activities to
reflect a particular industry and the organization’s strategy.
Depending on the industry within which the organization competes, each of these primary activities can have an
impact on its competitive advantage. For example, a distribution company such as UPS will clearly be more concerned
about its inbound and outbound logistics—how it receives and stores products and gets them to the end user. The fact
that UPS can accurately track the whereabouts of any of its parcels using sophisticated satellite technology and convey
this to its customers is a means of adding value.
Table 4.1 Primary activities within the value chain.
Inbound logistics
These activities cover receiving, storing, and distributing inputs to the product. They include material handling,
warehousing, inventory control, vehicle scheduling, and returns to suppliers.
Operations
These activities deal with transforming an organization’s inputs into final products such as machining, packaging,
assembly, testing, printing, and facility operations.
Outbound logistics
These activities are associated with collecting, storing, and distributing the product or service to buyers. Outbound
logistics include warehousing, material handling, delivery, order processing, and scheduling.
Marketing and Sales
This includes activities that make a product available for buyers to purchase and induces them to buy. It includes
advertising, promotion, sales force, quoting, channel selection, channel relations, and pricing.
Service
These activities enhance or maintain the value of products, such as installation, repair, training, parts supply, and product
adjustment.
CHAPTER 4 The Internal Environment: Value-Creating Activities
89
Table 4.2 Support activities.
Procurement
This activity deals with the process of purchasing resource inputs to support any of the primary activities. Inputs to the
organization’s productive process include such things as raw materials, office supplies, and buildings.
Technology
development
This activity covers an organization’s ‘know-how’, its procedures, and any use of its technology that has an impact upon
product, process, and resource developments.
Human resource
management
These activities include selection, recruitment, training, development, and remuneration of employees. They may support
individual primary and support activities, as occurs when an organization hires particular individuals such as economists.
They may also support the entire value chain, as occurs when an organization engages in company-wide pay negotiations.
Firm infrastructure
This consists of activities which usually support the entire value chain, such as general management, planning, finance,
accounting, and quality management. An organization’s infrastructure is usually used to support the entire value chain.
Support activities are there to ensure that the primary activities are carried out efficiently and effectively. The
four generic support activities are procurement, technology development, human resource management, and firm
infrastructure (see Table 4.2). The first three support activities may be associated with specific primary activities, while
firm infrastructure supports the entire value chain. As we saw with primary activities, each support activity can be
divided into a number of distinct activities to reflect a particular industry.
Each category of primary and support activities includes a further three activities which impact on competitive
advantage. These are direct and indirect activities, and quality assurance. Direct activities involve creating value for
the buyer, for example through product design. Indirect activities allow direct activities to take place, such as regular
maintenance. Quality assurance ensures that the appropriate quality of the other activities is maintained, for example
through monitoring and testing.
4.3 Evaluating the Value Chain
In deciding which activities to include in the categories that make up its value chain, an organization needs to be aware
of their contribution to its competitive advantage. The value activities included will involve an element of judgement
and subjectivity. Value chain analysis is much more than an evaluation of the discrete activities within the value chain.
To be effective, value chain analysis needs to recognize and understand the relationship or linkages between these
activities. Linkages are the relationships between the way one value activity is performed and the cost or performance
of another activity.11 The linkages between activities will not always be apparent. However, if the organization is to add
value it must appreciate how the manner in which one activity is performed impacts upon the cost and performance
of other activities.12 The aim is to see if a given activity can be undertaken differently and thereby improved, providing
competitive advantage. In addition, an organization must understand the relationship between its own value activities and the activities of suppliers, distributors, and customers; that is, it needs to appreciate its value chain system.
The Japanese car producers Honda and Toyota are well-known examples of organizations which add value by working
with suppliers and distributors to identify ways in which their value chains can be reconfigured to reduce lead times
and cut costs. The use of just-in-time (JIT) and lean production methods allows parts to be delivered only when they
are ready for assembly, thereby reducing lead times and cutting inventory costs.
4
4.2.2 Support Activities
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90
Toyota’s use of just-in-time production methods add value to the company. Source: © Bjoern Wylezich/Shutterstock.com
4.3.1 The Importance of Linkages within the Value Chain
An organization’s value-chain activities represent the cornerstone of competitive advantage. However, its value chain
should be seen not as a series of independent activities, but rather as a system of interdependent activities; that is, each
value-chain activity is related to the others by way of linkages in the value chain. For example, Toyota’s JIT methods are
part of the Toyota Production System (TPS). The TPS imbues all aspects of production in pursuit of the most efficient
methods of producing products. The TPS has evolved through years of trial and error to improve efficiency based on
the JIT concept. By eliminating both defective products and the associated wasteful practices, Toyota has succeeded
in improving both productivity and work efficiency.13 Therefore, competitive advantage can derive from the linkages
between its different activities as well as from the activities themselves.
Porter suggests that linkages can lead to competitive advantage in two ways: optimization and coordination. This is
a recognition that linkages will often involve trade-offs. For example, an organization may spend more on product
design and the quality of its materials in order to avoid greater maintenance costs during the product’s use. By optimizing these linkages between its activities an organization can achieve competitive advantage. Similarly, an organization can reduce its costs or improve its ability to differentiate by better coordinating activities in its value chain. An
understanding of linkages helps an organization to achieve competitive advantage by focusing on the relationship
between interdependent activities as well as individual activities. While the linkages between primary and support
activities are apparent, the linkages between primary activities may be more difficult to discern. For instance, better
servicing and maintenance of machinery will lead to a reduction in its downtime. The key to deriving benefit from linkages is to understand how each value-chain activity impacts on, and is impacted by, other activities.
Today many organizations outsource what they consider are non-core activities in their value chain to third party firms
(see Strategy in Focus 4.1). This is because other firms will have developed expertise in these non-core activities
CHAPTER 4 The Internal Environment: Value-Creating Activities
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and be capable of undertaking them at a lower cost. This allows organizations to focus on activities in their value
chain where they can add the greatest value. However, there are risks with outsourcing activities which, if undertaken
incorrectly, can damage the organization’s reputation and reduce its revenue. This illustrates how important it is for
an organization to identify all the linkages within its value chain if it is to mitigate the associated risks of outsourcing.
4
STRATEGY IN FOCUS 4.1 Outsourcing at British Airways
Chaos at British Airways. Passengers airside finding flights cancelled queue only to be given leaflets and told to find own hotels
and rebook flights . Source: © douglasmack/Shutterstock.com
British Airways came under pressure to explain the source of the power surge that the company says
triggered the computer system failure that sparked three days of travel chaos and left more than 75,000
passengers stranded worldwide. As shares of the parent company, International Airlines Group, fell,
electricity companies denied there were any issues with the power networks that serve Heathrow and the
surrounding area.
BA’s operations finally regained a semblance of normality at both Gatwick and Heathrow, the two airports
that were at the centre of the disruption after the computer system crash. Rival European group Ryanair said it
had back-up systems in place to deal with such problems. Kenny Jacobs, chief marketing officer, said Ryanair
had IT systems in three locations around Europe and if one went down, there were back-up systems at each of
its three centres in Dublin, Poland, and Madrid.
‘That’s what most businesses would do. We take IT very seriously’, he said.
Ryanair, said it had seen a surge in bookings because of BA’s problems. Analysts have estimated the BA
disaster, which forced the airline to cancel all flights out of London on one day, could cost the company as
much as £88m (€100m). Severe disruption continued for a number of days, particularly at Heathrow. Energy
4
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PART TWO Strategic Analysis
experts suggested BA’s problems could have been at a data centre or as a result of BA’s internal electricity wiring.
Companies often use data centres around the world.
Alex Cruz, BA’s chief executive, blamed the IT failure on an ‘exceptional’ power surge, which he said had been
so strong that it also disabled the airline’s back-up system. The statement has left many in the aviation and
energy industry confused. A spokesperson for Scottish and Southern Electricity Networks said, ‘there is no
record of a “power surge” on its network’ in the Harmondsworth area, where BA’s headquarters is situated. A
spokesperson for UK Power Networks, whose electricity networks cover Heathrow airport itself, also said there
were ‘no issues at all’. Mr Cruz has refused to resign over the scandal, telling the BBC: ‘I don’t think it would make
much sense for me to resign.’ Willie Walsh, head of International Airlines Group, stayed silent on the chaos.
The affair has shone an unfavourable spotlight on efforts to slash costs at BA, which includes its decision to
outsource several hundred IT jobs to specialists supplied by India’s Tata Consultancy Services. BA has vehemently
denied the outsourcing move was linked to its problems over the computer failure. Aviation and brand experts
have warned that BA now has a big job on its hands to recover its reputation with passengers. BA said it was
intending to operate a ‘full’ flight schedule at both Heathrow and Gatwick but added that it was still working to
return lost luggage to passengers who were separated from their bags during the chaos.
Source: Tanya Powley and Nathalie Thomas, ‘British Airways under pressure to explain source of power surge’, Financial Times, 30 May 2017. Used under licence
from the Financial Times. All Rights Reserved.
4.3.2 Managing Linkages within the Value Chain System
The extent to which an organization can manage the linkages between the value chains of others within the valuechain system may become an important competence and competitive advantage. Porter argues that in addition to
analysing its own activities, an organization should also seek to assess the benefits to be accrued from better links
with the value chain of its suppliers, distributors, and consumers. These linkages are similar to the linkages within
an organization’s own value chain in that the manner in which they are undertaken impacts upon the cost or performance of an organization’s activities. For example, Japanese automobile manufacturers manage external value chains
in order to facilitate JIT deliveries of parts which can be put to immediate use rather than being tied up in expensive
and unproductive inventory. The American retailer Wal-Mart manages the value-chain linkages between itself and its
suppliers. This enables Wal-Mart to leverage its massive buying power, while at the same time providing suppliers with
scale economies for their products through Wal-Mart stores.
How an organization manages the linkages between its own and other value chains will have an impact on how value
is created within the value chain system. For example, if an organization can change the configuration of a supplier’s
value chain to optimize the performance of their respective activities, it will benefit itself and the supplier, leading to
a win–win situation. In the same way, by improving the coordination between its own value chain and a supplier’s
value chain, both benefit. The extent to which an organization can appropriate some of these benefits will reflect the
bargaining power of its suppliers. Therefore, an organization should be prepared to influence the coordination of its
suppliers’ value chains and be prepared to negotiate to appropriate some of the rewards. The organization needs to
undertake the same analysis with its distributors if it is to lower its costs or improve its differentiation.
The consumer also has a value chain, and an organization’s product is an input into the buyer’s value chain. For buyers,
an organization needs to construct a value chain for them based on the activities that are relevant to how they use
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In seeking to influence the value chain of its suppliers, distributors, and consumers, an organization needs also to
address the make or buy decision. That is, does the organization want to undertake all the activities involved with
the product or service itself, or might it prefer to outsource some of these activities in its value chain? This evaluation
should be integral to the analysis it undertakes as part of its assessment of its own value chain. Many organizations
in both the public and private sectors make a conscious choice as to the value activities they perform internally and
those value activities that they are prepared to purchase. There is a recognition here of transaction cost economics;
that some organizations may be able to provide certain value-chain activities at a lower cost. Clearly, where these
activities constitute a core competence, organizations may prefer to keep them in-house. We look at transaction cost
economics in Chapter 8.
An organization’s own value chain analysis will help it to understand where it can add value in its activities and where
its costs in some activities may exceed its value. Financial considerations are important, but so too is an organization’s
strategic capability. If an activity underpins an organization’s strategic capability, that is, its ability to compete successfully in the marketplace, it will want to retain that activity. The decision an organization faces as to whether to
continue with an activity or outsource it to a lower-cost producer will depend on the extent to which that activity is of
strategic importance to it. Most organizations would be unlikely to outsource what may constitute the source of their
competitive advantage, but instead would seek to outsource lower-value activities to organizations that specialize in
these activities.
Campbell and Goold14 note that identifying the extent of value-chain overlaps between different businesses can also
be a source of synergy opportunity. For example, if two businesses within the same corporation purchase similar
components, economies of scale may result by combining these purchases. Or, if two businesses have overseas offices
in the same country, they could reap synergies by sharing premises, sales forces, and management.
4.4 SWOT Analysis
We briefly introduced SWOT analysis in Chapter 2 when we discussed the macro-environment. Those within the positioning school would argue that external analysis should precede the internal analysis of an organization’s resources
and capabilities. Irrespective of chronology, SWOT analysis can be usefully undertaken once an audit of the external
environment and the organization’s internal environment has been completed. Knowledge of an organization’s value
chain will help signpost where its strengths and any weaknesses may reside.
4.4.1 Integrating the Macro and Competitive Environments
SWOT analysis15 refers to strength, weaknesses, opportunities, and threats. Strengths and weaknesses refer to
the organization’s internal environment over which the organization has control. Strengths are areas where the
4
the product. This is important because the consumers of an organization’s product will assess that organization on the
benefits they derive from it. An organization’s ability to differentiate its offering will be a product of how its value chain
relates to the buyer’s value chain. Value for the consumer is created when an organization is able to lower the buyer’s
costs or improve differentiation for the buyer. The buyer’s perception of the value to be derived from a product will
determine an organization’s ability to charge a premium price.
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PART TWO Strategic Analysis
SWOT analysis allows an organization to determine the extent of the strategic fit between its capabilities and the needs of its
external environment. This implies that the organization has some understanding of the value-chain activities that underpin its strengths and weaknesses. In addition, its analysis of the markets and industries in which it competes needs to be
sufficiently robust if it is to be aware of real opportunities and threats that exist. SWOT analysis becomes more complicated
when existing strengths can quickly become a weakness. For example, such things as changes in consumer tastes, disruptive technologies, and new competitors will cause markets to change, thereby eroding an organization’s current strengths
and the source of its competitive advantage. A problem occurs when competitors are so busy investing in the capabilities
that provide them with their current strengths that they fail to recognize threats in their external environment which will
turn these strengths into a weakness. This is particularly the case where these threats emanate from outside their industry.
This analytical audit provides the organization with a better understanding of how it might best serve its markets. It
illuminates the strategic choices which best match the organization’s capabilities with the needs of its external environment. Yet, as we have noted, there can be a contradiction inherent in pursuing a strategic fit between an organization’s
strengths and the needs of its markets. As a result, SWOT analysis should not simply be about matching an organization’s
existing strengths to the needs of the external environment, but also about being aware of how the external environment may evolve. Over time these can move in different directions, making strategy formulation problematic.
A SWOT analysis for Barclays Bank is shown in Figure 4.2. Its strengths include its geographical scope of operations,
financial resources, and Barclaycard. Weaknesses include the dysfunctional culture resulting in scandals and high turnover of executive management (CEOs). Opportunities include divesting investment banking to reduce its exposure to
risk and making increasing use of digital technology to reduce its costs. Barclays faces threats from Apple disrupting
Internal Factors
Strength (S)
External Factors
4
organization excels in comparison with its competitors. Weaknesses are areas where the organization may be at a
comparative disadvantage. Opportunities and threats refer to the organization’s external environment, over which the
organization has much less control. We noted that a SWOT analysis may prove useful in both the macro-environment
and the competitive environment. However, the unpredictable nature of events in the macro-environment tends to
make the use of SWOT analysis more problematic.
Weaknesses (W)
• Geographical scope of operations • Libor scandal
• Confused corporate culture
• Financial resources
(is it an investment or retail bank?)
• Increasing dividends
• Largest credit card issuer in Europe • Executive management turnover
with Barclaycard
Opportunities (O)
• Divest/reduce investment banking
• Presence in emerging markets
(Africa is fastest-growing market)
• Industry consolidation
• Use of digital technology to reduce
cost/income ratio
Figure 4.2 SWOT analysis for Barclays Bank.
Threats (T)
• Apple disrupting payments market
• Fall in interest rates (impacts margins)
• On-going regulatory fines
• Slow growth in the global economy
• Litigation (PPI)
• Basal regulations
CHAPTER 4 The Internal Environment: Value-Creating Activities
95
the payments market, on-going regulatory fines, and litigation (PPI). This analysis provides some clear insights at a
corporate level. If we disaggregate Barclays Bank into its strategic business units, such as its retail, commercial, and
cards business, this provides a finer grain of analysis to assess its strategic choices.
For guidance on how to undertake a SWOT analysis visit the online resources and see the Working
through Strategy feature for this chapter.
www.oup.com/uk/henry3e/
4.4.2 Limitations of SWOT Analysis
Although SWOT analysis can be a powerful tool if used correctly, it also suffers from some drawbacks. One of
these is that it is not an end in itself but part of a process. It can provide useful signposts for the organization
but, as with all tools of analysis, it will not supply the strategic decisions. Some common criticisms of SWOT are
given below.
●
It often produces lengthy lists which are each accorded the same weighting. The reality is that not all threats
facing the organization will be weighted the same. For example, the impact of disruptive innovations will seriously undermine the competitive advantage of an organization, while other threats will have a less detrimental
effect.
●
Strengths and weaknesses may not be readily translated into opportunities and threats. For instance, an organization’s strength embodied in its resources and capabilities may be moving in the opposite direction to how its
market is developing.
●
Ambiguity: the same factor can simultaneously be characterized as both a strength and a weakness. For example,
the UK stationer and bookseller W. H. Smith has a store on most high streets. This makes it readily accessible for
consumers. At the same time, the fixed costs of its premises make it increasingly difficult to compete with online
retailers not encumbered with the same cost structure.
●
The same factor can also be an opportunity and a threat. For example, consumers can subscribe and download
newspapers on tablets, which benefits the newspaper publishing industry. At the same time, the reduction in
print readership is a threat to an industry with high fixed costs.
●
The analysis may be too focused within the industry boundary and miss the weak signals, tipping points, or
disruptive innovations which can restructure the organization’s industry.16
4
We can amalgamate the tools of analysis drawn from the macro-environment, the competitive environment, and an
internal analysis of the organization to produce a SWOT analysis. We can use scenario planning and PEST analysis to
identify the external opportunities and threats (OT) facing an organization. The organization’s internal strengths and
weaknesses (SW) can best be determined following an appraisal of its resources and capabilities, which reside within
the activities of its value chain. Why use this analysis? SWOT analysis allows an organization to assess the fit of its
current strategy to its changing environment, and to help turn potential threats into opportunities, and weaknesses
into strengths. It can help an organization to identify its resources and capabilities more clearly, and to assess whether
these are a benefit or a constraint to exploiting opportunities in the marketplace. Ultimately it can be used to help
formulate an organization’s strategy.
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Internal Factors
Strength (S)
External Factors
Opportunities (O)
Threats (T)
Weaknesses (W)
SO
WO
The organization makes
use of its strengths to
exploit opportunities
Managers develop options
that overcome weaknesses,
to be able to take advantage
of opportunities that exist
ST
WT
Managers develop options
which exploit strengths to
overcome threats
This is minimizing your
weaknesses to help you
avoid any threats
4
Figure 4.3 A TOWS analysis.
As a result of these limitations, TOWS analysis has been introduced. TOWS analysis allows managers to make strategy
formulation clearer by combining internal strengths and weaknesses to external opportunities and threats. In contrast,
SWOT analysis is a technique for audit and analysis. Therefore, a manager would utilize SWOT at the beginning of the
analysis, and TOWS afterwards to build upon the SWOT analysis. The four TOWS strategies are Strength/Opportunity
(SO), Weakness/Opportunity (WO), Strength/Threat (ST), and Weakness/Threat (WT). The benefit of combining the
internal and external analysis is to provide clarity and more robust decision making. This is shown in Figure 4.3.
If we continue with the Barclays Bank example, for SO we can say a viable option might be for Barclays to use its vast
financial resources to invest in the emerging and fast growing African market to build market share. For WO, it might
take a decision to focus primarily on retail banking, leveraging its presence on major high streets to attract customers
to its savings, loans, and mortgages. In developing options for ST, Barclays can use its knowledge of payment transactions and consumer brand to develop innovative, digital payment systems. This might best be accomplished in an
alliance with a software company, to produce an industry standard format. Lastly, with WT, Barclays might reorganize
its internal bonus payment system to prevent senior managers acting in their own interest and thereby mitigate the
payment of substantial regulatory fines. As with all tools analysis, TOWS is not a substitute for managerial judgement
but simply a useful tool to aid the decision-making process.
4.5 Organizational Performance
How can an organization assess its performance and keep its attention on its strategic aims? The choice of performance
measures is a challenge because these play a key role in strategy formulation, evaluating whether an organization’s
objectives have been achieved, and in compensating managers. Therefore, the purpose of assessing organizational
performance is to help the organization ascertain whether the strategies being implemented are actually adding value.
4.5.1 What is Performance?
At first glance this question may seem a little glib, perhaps even absurd. However, as we shall see, the use of different
performance criteria can produce conflicting results and lead to inappropriate or sub-optimal resource allocation decisions. To address performance, we must first address the fundamental question: why do businesses exist?17
CHAPTER 4 The Internal Environment: Value-Creating Activities
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The profit-maximizing assumption was contested by behavioural psychologists claiming that organizations consist
of shifting coalitions.19 This approach argues that organizational behaviour is determined by the interests and beliefs
of the dominant coalition(s). Some economists eschewed profit maximization and argued instead for market share or
sales maximization. Others suggested managers actually run companies based upon utility functions which include
profit but also include other elements. This idea of coalitions within and around organizations has found its expression
in stakeholder theory. However, whether the overriding objective of shareholders’ interest can be subordinated to a
multiplicity of other interests is an ongoing debate.
4.5.2 Maximizing Shareholder Value
If we consider privately owned and public limited companies, there is an assumption that these organizations are in
business to create value, and that the profit they produce is to be distributed among the owners of the business—the
shareholders. This perspective is associated with the Nobel prize winning economist, Milton Friedman.20 Friedman
advocated that an organization has only one social responsibility, which is to make as much profit for its shareholders
as it can. If we look at the reasons why some people hold shares, Friedman’s assertion has validity. Many shareholders
purchase shares in anticipation of capital growth. Of course, this capital growth must exceed what it costs them to buy
shares in the first place and what they could have earned if they had placed their money elsewhere—in other words,
their opportunity cost. See the Case Example: The Pursuit of Shareholder Value at the end of the chapter, which
considers alternative approaches to shareholder primacy.
If the role of corporations is to create value and distribute profit to their shareholders this brings us neatly to how corporate performance will be measured. There are accounting conventions that organizations follow but these vary from
country to country. Even within the same country managers can use their discretion to interpret and state profitability
figures. The main purpose of financial statements is to show the underlying economic performance of an organization.
The balance sheet and profit-and-loss account are the primary financial statements. The balance sheet shows a snapshot
of a company’s assets, liabilities, and capital at one moment in time. The profit-and-loss account shows the difference
between a company’s total revenue and its total expenses. However, a measure of traditional accounting profit may
not only misrepresent what the true profit might be but also lead to a misallocation of the resources. For instance, managers may be pursuing opportunities which may not fully cover their cost of capital.
To take account of the cost of capital, a number of different value metrics have been developed. Perhaps the most
widely adopted is economic profit (EP) and its variant economic value added (EVA).21 These metrics are discussed in
Section 4.5.4, ‘Financial Analysis’.
4
There is an assumption that the primary objective of organizations is to maximize profits to benefit shareholders.
Shareholders are individuals or groups who have invested their capital within an organization, and are therefore
deemed to be the owners. In their seminal work, Berle and Means18 cast doubt on profit-maximizing theories. They
were not questioning whether the objective of organizations should be to maximize profits for the shareholders but
whether this actually occurs. This was because of the existence of the principal–agent problem. This refers to the
separation of ownership from control within corporations. The owners are the principal who provide the capital but
control is in the hands of managers who act as agent on the principal’s behalf. A key issue is that each party has different access to information. This may allow the agent to act on his or her own behalf and against the principal’s interests.
Therefore, the question arises as to how the agent should be monitored and the costs that result from this.
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4.5.3 Meeting the Needs of Stakeholders
We have seen that when the focus is on owners there is a presumption that shareholder value is the dominant objective of the organization. An alternative approach is a view of the organization that serves the interest of stakeholders.
Freeman,22 defines stakeholders as those individuals or groups who affect or are affected by the achievement of an
organization’s objectives. These include customers, suppliers, employees, government, competitors, the local community, and, of course, shareholders. Those who advocate a stakeholder model dispute that the primary role of organizations is to create shareholder value.
4
Stakeholder proponents argue many different groups are affected by an organization’s decisions. They argue that the
role of management is to balance these stakeholder needs, rather than to simply focus on shareholders. Indeed, multinational corporations require executives to recognize that their actions can have effects beyond their nation’s borders
as a result of the globalized economy. The collapse of the US corporation Enron is a case in point; its impact was felt far
beyond the loss to shareholders.
The problem is that stakeholders have conflicting needs. As a result, the task of management in balancing these different interests becomes more fraught. This is because stakeholders have different objectives which leave managers trying
to balance multiple objectives. One way of trying to prioritize the different interests of stakeholders is to assess the influence they exert on an organization’s objectives. Mendelow23 proposed a model which ranks stakeholders according to
their power and interest. This is shown in Figure 4.4, which categorizes stakeholders according to how much power they
possess and the level of interest they show in what the organization does.
Power refers to a stakeholder’s ability to influence an organization’s objectives, while interest refers to their willingness
to influence the organization’s objectives. Clearly, if a stakeholder exhibits both high power and high interest, an
organization would be wise to consult them before taking any major decisions. Such a stakeholder might be a regulatory body concerned with competition and consumer affairs. For example, in 2016 the European Commission ruled
that Apple owed £11bn (€13bn) in back taxes to the Irish government. The European Commission was targeting
the arrangement between Apple and the Irish government on the grounds that it gave Apple an undue tax advantage, which distorted competition. Apple and the Irish government have strongly contested the allegation. Other
POWER
Low
High
Low
Stakeholders
with the least
influence over
organizations
INTEREST
Stakeholders
with the most
influence over
organizations
High
Figure 4.4 The stakeholder power–interest matrix. Source: Adapted from A. Mendelow, Proceedings of 2nd International Conference on Information Systems,
Cambridge, MA, 1991
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A view from space of the consequences of BP’s Deepwater Horizon rig explosion in the Gulf of Mexico. Source: © NASA/GSFC, MODIS Rapid Response
stakeholders may exhibit high power but relatively low interest. Institutional shareholders are routinely placed within
this sector. However, there is a trend for institutional investors to become increasingly interested in the activities, especially executive remuneration, of organizations in which they choose to invest. This is as a result of the concerns of the
individuals whose funds institutional shareholders manage.
Similarly, government agencies may have a benign interest in the activities of organizations and only be forced to
exercise their legislative powers when organizations behave in an unacceptable manner. For example, BP’s Deepwater
Horizon rig explosion in the Gulf of Mexico in 2010 led to an investigation by US Congress and billions of dollars paid
in compensation. Sternberg24 argues that trying to balance different stakeholder needs does not work. Freeman’s
definition of stakeholders leads to a number of different stakeholder needs, and stakeholder analysis is unable to differentiate which stakeholders should be selected.
Stakeholders who have low power but a high level of interest in the organization’s activities can form coalitions. These
coalitions often temporarily coalesce around a single social issue and can be a powerful force for change. This is often seen
during environmental disasters, for instance when the oil tanker Exxon Valdez spilt oil in Prince William Sound, Alaska,
resulting in substantial damage to wildlife and the environment. During such times environmental pressure groups benefit from a groundswell of public opinion which, for a time, may increase their power when negotiating with corporations.
Therefore, even when an organization’s priority is to create value for its shareholders, it cannot afford to do so without
some understanding of the expectations of stakeholders. As such, their criteria for successful performance may differ
markedly from purely shareholder maximization. As we saw in Chapter 1, some organizations make a point of including stakeholder interest in their core values and vision. See Strategy in Focus 4.2, which illustrates IKEA’s focus on the
local community, while also marketing its products.25
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4
STRATEGY IN FOCUS 4.2 IKEA and Stakeholders
Blue-sky thinking from IKEA . Source: © JuliusKielaitis/Shutterstock.com
The Swedish home furnishing retailer, IKEA, has revealed its plans for a new store in the Royal Borough
of Greenwich, UK. IKEA’s unique Greenwich store proposal will feature new design elements, such as a roof
pavilion, a biodiverse roof garden, community garden, and multifunctional spaces. The Greenwich store has
been designed with stakeholders in mind. Commenting on the store plans, an IKEA manager, said,
This is an exciting development for IKEA that has the customer, the local community and the environment at its
heart. We want to create a unique and exciting space that will act as a place to meet, learn, share and shop—
enhancing the ways we engage with our . . . stakeholders. The new IKEA Greenwich will be an innovation hub for
home furnishings and sustainable retail.
A community hub for Greenwich
The new store will also have a restaurant, as well as an inspirational home furnishing offer. IKEA Greenwich aims
to offer managed events and programmes for a variety of audiences. The roof will also offer recreational space
for its co-workers.
IKEA has a vision to create a better life for the many people. Our new IKEA Greenwich store will create a unique and
meaningful customer experience. In addition to being a good neighbour to local residents, we are delighted that
more people in London will be able to experience our inspiring range of quality, well-designed, functional and
affordable products.
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As a business IKEA is dedicated to sustainability across all aspects of its operations. The Greenwich store is
designed and will be built to ensure energy and resource efficiency, including the use of solar panels, rainwater
harvesting, and energy saving and generating technology.
‘Sustainability is at the heart of everything we do at IKEA—from the energy and resources we use and the way
we work with communities to the way we can support our customers to save energy, water and waste at home
and live more healthily. In Greenwich it’s fantastic to have the opportunity to put those principles into practice,
working together with the local community and stakeholders to create a unique experience that shows how
sustainability can be accessible, affordable and attractive for everyone’ said the Head of Sustainability at IKEA
UK & Ireland.
The store will feature seventy-five cycle spaces and will offer twenty electric-car-charging points. The
company actively encourages its co-workers and customers to use public transport where possible and will
invest in the local area to increase accessibility to the store. The new store will create 500 jobs across a wide
range of positions. As the company becomes a part of the Greenwich community, IKEA will work with Greenwich
Borough Council to recruit locally as much as possible. IKEA is committed to investing in its people and paying
its co-workers a meaningful wage that supports the cost of living.
Source: ‘IKEA unveils plans for its new store in Greenwich’, 30 January 2017, www.ikea.com. Reproduced with the kind permission of IKEA UK and IE
We return to these issues in Chapter 12, when we evaluate shareholder and stakeholder perspectives in greater
detail.
4.5.4 Financial Analysis
A view of the role of organizations to simply create value for shareholders is increasingly disputed. Nevertheless, an
organization needs to be able to assess the performance of its managers. The choice of performance measurements
will reflect the corporate governance frameworks in each country. For example, some European countries such as
Germany, adopt a two-tier board of directors which includes employee representation. As result, their corporate performance measurements will go beyond financial measurements. While companies based on what Sternberg refers to
as the Anglo-American model will adopt performance measurements which reflect shareholder value.26 The overriding concern in quoted companies, particularly in the US and the UK, continues to reflect shareholder value.
Measuring an organization’s performance is necessary to understand whether the strategies being implemented actually add value to the organization.27 Let us accept for the moment that the role of organizations is to create value for
its owners. Then, the use of performance measurements acts as a control on management to ensure they fulfil their
fiduciary duty to shareholders. All organizations undertake investment decisions where returns will only be known
with certainty at some point in the future. This necessitates some form of calculation to approximate what the present
value of future income is worth. The problem is that as future cash flows are uncertain, this makes any calculation
based upon them fraught with difficulties. Therefore, management tends to rely upon more traditional accounting
measures.
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A sustainable IKEA store in the UK
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The result of using traditional financial measures is that the emphasis is upon past financial performance. In addition,
the financial measures often used by corporations tend to draw attention to short-term performance only. We can
briefly review some of the traditional financial measures used by corporations to assess their performance.
1. Return on capital employed (ROCE) is a performance ratio commonly used by organizations. It is calculated by dividing profit before interest and tax by capital employed. Capital employed refers to fixed assets plus current assets less
current liabilities (creditors: amounts due within one year). As there is some variation of the terms in the denominator
and the numerator, it is useful to find out what definitions have been used in any ratios quoted. The formula is:
Profit before interest and tax
× 100
Capital
4
The ROCE figure should ideally reflect the level of risk in the investment and can be compared with interest rates
for other investments where risk is minimal, such as bank accounts. It is useful to compare the figure over time. If
managers want to know how this figure can be improved, they need to work out two subsidiary ratios.
2. The profit margin or return on sales (ROS) measures the percentage return on sales (net profit per £1 of sales).
The formula is:
Profit before interest and tax
× 100
Sales
Organizations can operate on thin profit margins as long as they have substantive volume sales. Profit margin can
be improved therefore by increasing the selling price and/or reducing costs.
3. Capital turnover measures the level of activity in the organization as reflected by sales in relation to the capital
employed; that is, it measures the number of times the assets (the capital employed) are utilized or turned over to
achieve those sales. The formula is:
Sales
Capital employed
For capital turnover, we require a high level of activity for a low level of investment. Capital turnover can be improved
by increasing sales activity or decreasing capital employed, or by selling off fixed assets that are no longer used.
These three performance ratios are interrelated, as the profit margin multiplied by the capital turnover gives the return
on capital employed. A business can improve its return on capital employed by reducing costs and/or raising prices,
which will improve its profit margin. Alternatively, it can increase its sales volume and/or reduce its capital employed,
which will improve its capital turnover. It is important to remember that financial ratios require comparison if they are
to be useful. The fact that an organization makes a return on investment of 15 per cent may sound great, until you discover that the industry average is 23 per cent. Similarly, comparison with key competitors can draw attention to where
an organization might need to benchmark its performance. This is discussed later in the chapter.
Discounted cash flow analysis
To understand discounted cash flow, it is helpful to first understand the time value of money and the concept of
opportunity cost. The time value of money simply reflects the fact that as individuals we usually prefer to have £100
today rather than £100 in three years’ time. In order to forego £100 now for a higher sum in the future, we require compensation. If we are willing to sacrifice £100 now to receive £105 in one year’s time, our rate of compensation—interest
CHAPTER 4 The Internal Environment: Value-Creating Activities
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rate—is 5 per cent. Opportunity costs simply reflect that individuals have alternative uses for their funds. The opportunity cost is an individual’s return on the next best investment they could have made. Furthermore, if there is inflation,
an individual should be compensated for the loss in purchasing power. Finally, there is an element of risk. The amount
received in the future may be less than expected or not occur at all.28
For example, an individual considering an investment of £1,000 for one year needs to be compensated. A return of 2 per
cent may be required for the time value of money. If inflation is expected to rise to 3 per cent over the year, then a further
3 per cent compensation is required. This is because if inflation is 3 per cent, it will cost £1,030 to purchase the same goods
in one year’s time, as today. Thus, the investment would need to produce a rate of return of 5.06 per cent.
This is worked out as follows: (1 + 0.02) (1 + 0.03) −1 = 0.0506.
4
If we assume there is no uncertainty about cash flows, then the 5.06 per cent can be seen as a risk-free return (RFR). In
reality, buying UK government bonds is effectively a risk-free return because the government can always repay its debts.
The degree of uncertainty about different investments requires that individuals also need to be compensated for
different levels of risk. Therefore, the required rate of return for an investor is their risk-free return + a risk premium.
Including a risk premium will increase the total rate of return from 5.06 per cent, to say, 9 per cent. At this rate of return,
an individual is fully compensated for the time value of money.
To help managers choose between different investment decisions it is useful if they can estimate the present value
of future income streams. That way they can compare the relative benefits of an investment decision. One method a
manager might use is discounted cash flow (DCF). Discounted cash flow discounts all future cash flows by the time
value of money. This allows each future cash flow to be expressed as an equivalent amount of money received in the
present. The compound interest formula is:
F = P (1+ i )
n
where F = future value
P = present value
i = interest rate
n = number of years over which compounding takes place.
If an individual saves £100 in an account with interest at 6 per cent per annum, after three years the account will be
worth £119.10.
By rearranging the compound interest formula, we can work out the present value, P . Thus, the question becomes how
much money must I save now to get £119.10 in three years?
P =
P =
F
(1+ i )n
119.10
(1 + 0.06 )3
= 100
Here, we have discounted £119.10 back to a present value of £100. Therefore, by converting all future values into their
present value equivalents, the value of different investment decisions can be readily compared.
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In order to take account of the cost of capital, economic profit (EP) was introduced. An organization makes an economic profit if it generates a return greater than that required by the providers of finance given the risk class of investment. The formula is:
Economic profit = Operating profit before interest deduction and after tax deduction - (Invested capital x WACC)
Where WACC is the weighted average cost of capital, or required rate of return.
For example, assume a company’s weighted average cost of capital is 10 per cent and it utilizes £1,000,000 of capital. If
this produces an operating profit before interest and after tax of £180,000, then:
EP = £180,000 - ( £1,000,000 × 0.10 )
4
= £80,000
A major advantage of economic profit over the traditional accounting profit is that it encourages managers to focus
on the cost of using capital in their strategic business unit (SBU). It can also be used to evaluate strategic options that
produce returns over a number of years. Organizations which include Coca-Cola, AT&T, Walt Disney, Volkswagen, and
Barclays Bank have migrated away from traditional ROCE measures towards EP and economic value added (EVA).
Economic value added (EVA) was developed by US consultants Stern Stewart and Co., to address some of the shortfalls
in EP. It is worked out by taking a company’s operating profit after tax minus its cost of capital. If the net present value
of the resulting figure is positive, the organization can be seen to be adding value for its shareholders. If it is negative,
the organization’s resources could be usefully employed elsewhere.
EVA = Adjusted operating profit after tax—(Adjusted investment capital x WACC).
In an attempt to measure the extent of wealth created for shareholders by companies Stern Stewart also proposed
a wealth added index (WAI). The idea is that organizations create value for shareholders when their returns to these
investors, which include capital growth and dividends, are greater than investors require for keeping their money in
shares. To calculate WAI, you start with the increase in market capitalization for a share over a certain period, say five
years. You deduct any increase in the value of shares over that time period which was as a consequence of money
provided by shareholders; this is usually from rights issues. Rights issues are shares offered to existing shareholders at
a discount to the current share price. Add back any cash provided to shareholders in the form of dividends and share
buy backs. Finally, deduct the required rate of return on the money provided by shareholders for the given period. If
the value of its shares grew more than the rate of return required by investors, then the organization created value.
Conversely, if the growth was less than the return required by investors, the organization destroyed value.
4.6 The Balanced Scorecard
The balanced scorecard was developed by Kaplan and Norton29 as a means for organizations to measure their
performance from a wider perspective than traditional financial measures. Kaplan and Norton’s research identified
two major problems with corporate strategies. The first was that most companies measure their performance using
financial ratios. These measures only provide a snapshot of how a company performed in the past. What they do not
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The balanced scorecard is an attempt to overcome these two weaknesses. It is not about formulating strategy,
but an aid to understand and check what you have to do throughout the organization to make your strategy
work. Financial measures are important, but they reflect the results of actions that have already been taken.
They propose supplementary operational measures which more clearly highlight an organization’s future performance. These include customer satisfaction, internal processes, and innovation and improvement activities.
As they state, ‘the scorecard wasn’t a replacement for financial measures; it was their complement’. The balanced
scorecard then provides managers with a more comprehensive assessment of the state of their organization. It
enables managers to provide consistency between the aims of the organization and the strategies undertaken
to achieve those aims.
The balanced scorecard allows an organization to evaluate its respective strengths and weaknesses from four different
perspectives: a customer perspective, an internal perspective, a financial perspective, and a future perspective. The idea
is that an organization’s perspective of how it sees itself and how the outside world views it can be shown by integrating these four perspectives into a single balanced view. Assume, for example, that an organization wants to improve its
market share. Using a balanced scorecard approach the organization would need to translate what this actually means.
For instance, what are the measures that it needs to undertake to increase its customers? This then leads management
to assess what changes it needs to make within the organization to accomplish this. Once the need for internal change
is understood, it is then possible to assess what new skills and competencies the organization needs to acquire to
improve its performance. Norton and Kaplan outline a set of measures and yardsticks that organizations can use for
each of these steps.
The balanced scorecard approach looks at an organization from four perspectives.30
1. How do we look to shareholders? This financial perspective would include measures such as cash flow, increase
in sales, and ROCE, which we covered when we looked at traditional financial measures earlier.
2. How do customers view us? The customer perspective measures include an organization’s market share, since
this will be driven by customers’ perceptions of its products vis-à-vis its competitors’ products. It can also include
the extent to which customers are prepared to endorse new product offerings.
3. What must we excel at? The internal business perspective measures will reflect such things as cycle times, productivity, and quality.
4. Can we continue to improve and create value? The innovation and learning perspective includes measures that
take account of the speed and efficiency of new product development, reflecting a technological leadership goal.
In the anniversary edition of the Harvard Business Review, the balanced scorecard was listed as one of the fifteen most important management concepts to be introduced within its pages. However, when assessed in
4
do is show how well an organization might perform in the future. When Kaplan and Norton tried to find out which
factors determine an organization’s success, they uncovered a number of factors. These were customer satisfaction
and loyalty, employee commitment, and the speed at which organizations learn and adapt. The second issue was a
gap between an organization’s strategy and its implementation by employees. This was because many organizations
simply issued strategic statements that their employees failed to understand. Kaplan and Norton found that strategy
was rarely translated into action because it was simply not translated into measures that employees could make sense
of in their everyday work.
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terms of satisfaction by organizations, the balanced scorecard rated below average. The list of companies that have
used this approach include the Royal Bank of Scotland, Exxon Mobil, Ericsson, the Swedish insurance company Skandia, BP Chemicals, and Xerox. In addition, the balanced scorecard is also popular with public sector organizations.
4
Criticisms of the balanced scorecard coalesce around the measurements it leaves out, such as employee satisfaction and
supplier performance. However, this might be because what an organization chooses to measure is often what it finds
easy to measure. Another problem is that many organizations suffer from information overload as they go from measuring a few factors to measuring too many factors. One of the greatest failings is that organizations do not use the measurements to motivate people because managers do not sufficiently link measures to a programme of actions. In this respect,
identifying the right things to measure is merely the starting point. If organizations are to achieve a sustainable competitive advantage, they need to understand better the role of intangibles, such as brands, as well as their own people.
The balanced scorecard may provide a bridge between the needs of shareholders and the needs of stakeholders.
Concern about the impact of their activities on the environment is forcing many companies to think hard about ways
in which they can reduce their carbon footprint. For example, between 2019 and 2021, the Swedish car manufacturer,
Volvo, plans to introduce five 100 per cent electric models, and ensure the rest of its petrol and diesel range has an
hybrid engine of some form.31
In summary, Kaplan and Norton’s balanced scorecard takes traditional financial performance measures and complements these with criteria which measure performance from three additional perspectives: customers, internal business processes, and learning and growth. The balanced scorecard helps prevent the underachievement of strategic
goals that result from an overemphasis on short-term financial measures. By adopting a more balanced approach,
the organization can actively pursue strategies that achieve its aims by setting performance measures that have some
correlation with these strategies. In addition, this approach also takes account of the different expectations of stakeholders, recognizing perhaps that maximizing shareholder value is not a prime motivator for employees or customers.
4.7 Benchmarking
Why do some organizations excel at some practices and activities while others do not? Can something be learned from
the way in which successful companies carry out their practices that will improve your own company’s performance?
This is the essence of benchmarking. Benchmarking involves comparisons between different organizations with a
view to improving performance by imitating or, indeed, improving upon the most efficient practices. This should not
be limited to competitors within the same industry, but instead be measured against any organization that has a
reputation for being the best in its class.
In Japan benchmarking is practised through what is called Shukko.32 This is where employees work with other
organizations and acquire new practices which will benefit their organization. Shukko may lead to the transfer of
technology between employees and/or organizations, and also provide for management development. However,
its key advantage is the acquisition of specific knowledge which is lacking in the organization. In the US, the Xerox
Corporation, widely credited with developing benchmarking, defines it as ‘a continuous process of measuring our
products, services, and business practices against the toughest competitors and those companies recognized
as industry leaders’. A key to successful benchmarking will be the open learning that is allowed to take place
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Table 4.3 The Xerox approach to benchmarking. Source: M. Zairi, Benchmarking for Best Practice—Continuous Learning
through Sustainable Innovation, Butterworth Heinemann, 1996
Planning
1 Identify what is to be benchmarked.
2 Identify comparable companies.
3 Determine data collection method and collect data.
Analysis
4 Determine current performance ‘gap’.
5 Project future performance levels.
Integration
6 Communicate benchmark findings and gain acceptance.
7 Establish functional goals.
8 Develop action plans.
9 Implement specific actions and monitor progress.
10 Recalculate benchmarks.
between organizations. Clearly, organizations that are not competitors will be less concerned about sharing best
practice.
For example, in order to improve the service on its frequent-flyer programme, British Airways visited the Oriental Hotel
in Bangkok. The Oriental Hotel has a reputation for looking after and pampering its guests. Thus, British Airways was
able to improve upon its practices on how to record details of its customer preferences. The Xerox approach to benchmarking is included in Table 4.3 and involves ten sequential steps. The starting point is for an organization to identify
what it wants to benchmark in order for it to identify suitable companies to benchmark against. Benchmarking should
not be confined to your own industry but the net should be spread widely to truly capture best practice. The end goal
is for the organization to reach a level of maturity in which it attains a leadership position by having benchmarked
practices fully integrated into its own processes.
Benchmarking exposes organizations to state-of-the-art practices and, by inculcating a continuous learning process, can help engender an organizational culture that actively pursues change and innovation. In this respect, it
can be a vehicle for empowering employees and optimizing their creative potentials. The downside is that some
organizations may harbour unrealistic expectations about what benchmarking can achieve. The choice of companies to benchmark against will require managerial skill and time to ensure that an appropriate match is obtained.
Even where benchmarking practices can be formulated into organizational objectives, unless managers can
facilitate a cultural environment that embraces change and innovation, these ‘best practices’ will simply fail at the
implementation stage.
Summary
In this chapter, we have introduced an important debate within strategic management; whether the industry context
in which an organization finds itself is the main determinant of its performance, or whether there are internal factors
within an organization which may more readily account for how well that organization performs. The former approach
is characteristic of the positioning school and the work of Michael Porter. The latter is associated with the resourcebased view of competition and is addressed in Chapter 5.
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Action
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We evaluated value chain analysis as a tool to assess an organization’s activities by showing where these activities add
value. Organizations add value through the configuration of their value-chain activities and the linkages between
these activities. Organizations also add value through the linkages with their suppliers, distributors, and consumers;
this process is referred to as the value chain system.
We revisited SWOT analysis, pointing out that to be of benefit it should include a prior analysis of the macro- and
competitive environment. SWOT is a much-used tool of analysis primarily because it is relatively easy to use. That said,
it has limitations: for example, the analysis may be too focused within a firm’s industry boundary and some factors can
be seen as both a strength and a weakness.
4
We saw that the choice of performance measure must first address a more fundamental issue: who is the organization
there to serve? We explored different financial measurements of organizational performance, which include the cost
of capital in the decision making. We also evaluated the balanced scorecard as an attempt to actively link strategy to
an organization’s objectives.
We concluded the chapter with a discussion of benchmarking. We noted that benchmarking should not be limited
solely to direct competitors or those within the same industry. An organization should be willing to compare itself
against competitors outside its industry.
CASE EXAMPLE The Pursuit of Shareholder Value
The Status Quo
In the American Business Model (ABM), or the Washington consensus as it is often called, there is an expectation that the free market should reign supreme. In essence, that means little interference by the government in
the activities of businesses. Countries such as the UK, the US, Australia, and others have endorsed the ABM to
varying degrees. Under this model, the belief is that companies owned by shareholders should be managed in
such a way that allows them to pursue and maximize shareholder value. All other considerations are considered
secondary, at best, and irrelevant to the functioning of the corporation, at worst.
There is a belief that if such a company is not performing well it will be the subject of a takeover. This
then acts as a constraint on the behaviour of CEOs who may eschew the pursuit of shareholder value. Of
course, the reality is that takeovers are more about maximizing synergies between companies. When a
company becomes the target of a bid, the bidder is merely indicating that it believes it can release greater
shareholder value than the target company. At least, that’s the theory. In reality, takeovers are often about
CEO hubris.
In the pursuit of shareholder value, we have seen a disastrous takeover of ABN Amro by Royal Bank of
Scotland (RBS). At the time of the crisis RBS was the world’s biggest bank. By 2017 it had announced yet
another substantial loss of £7bn—making up cumulatively some £58bn of losses since 2008. It is now even
clearer than it was in 2008 that had the British government not stepped in, taking a vast £45bn stake, RBS
would have gone bankrupt. The government’s aim was to contain a widespread banking panic and shore up
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consumer confidence in the banking sector. As with the US government’s intervention after the collapse of
Lehman Bros, the option of letting market forces deal with the situation would, arguably, have made matters
considerably worse.
In one way, £45bn has rarely been better spent in the UK; but, in another, a clutch of hard questions
that would have been asked if RBS had gone bust were avoided. How could it be that RBS’s managers and
shareholders could ever have allowed it to grow so large when so much of what it was doing was not just
valueless, but actively value destroying? Why were the regulatory authorities, which oversee the activities
of RBS, not more alert to what was going on? Instead of the checks and balances one would expect from a
regulatory authority, RBS seems to have been given the ‘green light’ with all its activities. A major problem
is that if the board of directors doesn’t understand the financial activities they engage in, what hope has
the regulator?
The Anglo-Dutch consumer goods
company, Unilever, with brands ranging from Timotei shampoo to Ben
& Jerry’s ice cream, tends to adopt
a more enlightened approach. Its
CEO, Paul Polman, is concerned with
unemployment, global warming, and
individual greed as he seeks to build
an environmentally sustainable business. He puts some of the blame for
these ills on the most influential management theory of the past three
decades: the idea that companies
Unilever is a Dutch-British transnational consumer goods company producing food,
should aim above all else to maximize beverages, cleaning agents, and personal care products . Source: © JPstock/Shutterstock.com
returns to shareholders.
Since becoming CEO in 2009, Mr Polman has stopped Unilever from publishing full financial results every
quarter. He refuses to offer earnings guidance to equity analysts. He has introduced a ‘sustainable living plan’
the purpose of which is to grow the business, while at the same time reducing Unilever’s carbon footprint.
Their aim is stated as a desire, ‘to grow our business in the right way so that our consumers, employees, suppliers, shareholders and communities all benefit’. In 2016 their eighteen Sustainable Living brands grew fifty
per cent faster than the rest of the business. And they delivered over sixty per cent of the company’s growth.
Unilever defines a Sustainable Living brand as one that combines a strong purpose with delivering a social
or environmental benefit. As a consequence, Mr Polman has attracted long-term investors, particularly in
emerging markets.
A Broken System?
The pursuit of shareholder value has yielded some perverse results. The fashion for linking pay to share prices
has encouraged some bosses to manipulate their share price. For example, a manager with share options gets
nothing if the share price misses its target, so he may take unwise risks to hit it. This short-term approach is
4
Unilever’s Sustainable Long-Term Growth
4
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particularly rife on Wall Street. For instance, the average time that people hold a stock on the New York Stock
Exchange has tumbled from eight years in 1960 to only four months by 2010. In order to achieve these shortterm results, some firms reduce expenditure on research and innovation. The effect of this is to deny future
growth while increasing this year’s profits. The management thinker, Peter Drucker, once stated ‘long-term
results cannot be achieved by piling short-term results on short-term results’.
One study shows that publicly listed companies have invested only four per cent of their total assets, compared with ten per cent for comparable privately held companies. A second shows that eighty per cent of managers are willing to reduce spending on R&D or advertising to hit the numbers. Modern capital markets do,
however, like Amazon which has never found it hard to attract investors, despite the way it ploughs its revenues
into long-term plans for future growth. That said, publicly quoted companies cannot ignore the discipline of
the market. For example, in 2017 Unilever was approached by Kraft Heinz in an opportunistic £115bn takeover,
which it successfully rebuffed. That unexpected bid forced Unilever to undertake a review in which it committed
to increasing its operating margins to twenty per cent by 2020. At the same time, Mr Poulson emphasized that
Unilever will continue to invest in its brands for long-term growth.
The critics tend to make a distinction between long-term value (good) and short-term value (bad). But what
is wrong with making regular checks on your performance? A company’s quarterly results may tell you something about its long-term health, as well as its performance over the previous quarter. Those who endorse shareholder value as an overriding objective for the corporation argue that the critics have failed to produce a viable
alternative measure of success. Many critics of the shareholder model embrace a ‘stakeholder’ model instead
which takes account of the different interested parties that are affected by a company’s activities. Supporters
of shareholder value argue that this is too vague to be much of a guide. Who are a company’s stakeholders, and
how should their competing interests be weighed against each other? This becomes unclear. One advantage,
albeit imprecise, of the use of company’s share price is that it may provide a clear external measure by which
managers can be judged.
Novo Nordisk
The Dutch pharmaceutical multinational, Novo Nordisk, is based in Copenhagen and was founded in the 1920s
to make insulin. The company now controls over half the market for insulin. Again, we have a CEO, Lars Sorensen,
whose approach to leadership would be atypical in the US, but clearly not in Scandinavia. Novo Nordisk relies
upon its treatment of diabetes for eighty per cent of its revenue. Its market value is around £85bn. Instead of
simply selling expensive, differentiated insulin products to maximize its profits, it adopts a dual approach. It also
sells high-quality generic products, human insulin, for countries and populations that can’t afford the advanced
products that the more affluent patients want. By adopting this enlightened approach, Novo Nordisk has considerably enhanced its corporate reputation.
Novo Nordisk measures its results using a triple bottom line. Their philosophy is that corporate social
responsibility is simple; maximizing the value of your company over a long period of time. This is because in
the long term, social and environmental issues become financial issues. In other words, Mr Sorensen believes
that if companies keep polluting then they will face stricter regulations, and energy consumption will become
more costly. Similarly, if companies don’t treat employees well, don’t behave as good corporate citizens in their
local communities, and don’t provide inexpensive products for poorer countries, governments will impose
regulations on such firms that will end up being very costly.
Clearly, the pursuit of shareholder value is not the only game in town.
CHAPTER 4 The Internal Environment: Value-Creating Activities
111
Questions
1. What are the key differences between companies which pursue shareholder value and those who pursue
sustainable long-term growth?
2. Why are some shareholders attracted to sustainable long-term value?
Sources: ‘The pursuit of shareholder value is attracting criticism—not all of it foolish’, The Economist, 24 November 2012; ‘The best performing CEOs in the world’,
Harvard Business Review, November 2015; Will Hutton, ‘Vast losses at RBS are a legacy of a failed system’, The Observer, 26 February 2017; ‘Unilever’s ambitious
moves aim to unlock value’, Financial Times, 6 April 2017; www.unilever.com ; Peter Drucker, ‘Post-capitalist Society’, 1993
1. Even when they have similar resources, why do some organizations perform better than other
organizations when competing in the same industry?
2. What factors should an organization consider when it decides to outsource activities within its value chain?
3. Why does an organization’s choice of performance measures depend on whom it seeks to serve? Discuss
with reference to shareholders and stakeholders.
Discussion Question
It is not value chain analysis per se which is important for competitive advantage, but an understanding of the
linkages in the value chain system. Discuss.
Research Topic
What are the value-chain activities for the Spanish retailer Zara. How is Zara able to manage successfully the
linkages in its value chain system?
Recommended Reading
There are many books dealing with the responsibilities of organizations. One that benefits from being written
by a practitioner who has influenced the corporate governance debate is:
A. Cadbury, Corporate Governance and Chairmanship—A Personal View, Oxford University Press, 2002.
A key reading to understand value chain analysis is the work of Michael Porter. It was Porter who developed
value chain analysis and remains the best expositor.
● M. E. Porter, Competitive Advantage, chapter 2, Free Press, 1985.
●
For a discussion of qualitative as well as quantitative measures of performance, see:
●
R. S. Kaplan and D. P. Norton, ‘The balanced scorecard—measures that drive performance’, Harvard
Business Review, vol. 69, no.1 (1992), pp. 71–9.
4
Review Questions
112
PART TWO Strategic Analysis
www.oup.com/uk/henry3e/
Visit the online resources that accompany this book for activities and more information on the internal
environment.
References and Notes
M. E. Porter, Competitive Strategy, Free Press, 1980.
2
For a collection of articles which deal with differential firm performance, see S. Segal-Horn (ed.), The Strategy
Reader, 2nd edn, Oxford University Press, 2004.
3
See Porter, n. 1.
4
R. P. Rumelt, ‘How much does industry matter?’, Strategic Management Journal, vol. 12, no. 3 (1991), pp.
167–85.
5
G. Hawawini, V. Subramanian, and P. Verdin, ‘Is performance driven by industry or by firm-specific
factors? A new look at the evidence’, Strategic Management Journal, vol. 24, no. 1 (2003), pp. 1–16.
6
For an introduction to the resource-based view of strategy, see C. K. Prahalad and G. Hamel, ‘The core
competence of the corporation’, Harvard Business Review, vol. 68, no. 3 (1990), pp. 79–91; G. Hamel and
C. K. Prahalad, ‘Strategy as stretch and leverage’, Harvard Business Review, vol. 71, no. 2 (1993), pp. 75–84;
and R. Grant, ‘The resource-based theory of competitive advantage: implications for strategy formulation’,
California Management Review, vol. 33, no. 3 (1991), pp. 114–35.
7
See Porter, n. 1, chapter 2.
8
For a discussion of the role of activity systems within strategy, see M. E. Porter, ‘What is strategy?’, Harvard
Business Review, vol. 74, no. 6 (1996), pp. 61–78.
9
This section draws heavily upon Porter, n. 1, especially chapter 2, which contains a discussion of value chain
analysis and competitive advantage.
10
See Porter, n. 1.
11
See Porter, n. 1, p. 48.
12
Where an organization’s activities are embedded within its routines and form part of its culture, it is often
difficult to identify clearly where value is derived. Hence, this may form the basis of competitive advantage.
13
See http://www.toyota-global.com/company/vision_philosophy/toyota_production_system/origin_of_the_
toyota_production_system.html.
14
A. Campbell and M. Goold, Synergy: Why Links between Business Units often Fail and How to Make Them
Work, Capstone, 1998.
15
The introduction of SWOT analysis is widely associated with Kenneth Andrews, see K. R. Andrews, The
Concept of Corporate Strategy, Irwin, 1971.
16
For a discussion of tipping points, see M. Gladwell, The Tipping Point—How Little Things Can Make a Big
Difference, Little Brown, 2000; for disruptive innovations, see J. Bower and C. M. Christensen, ‘Disruptive
technologies: Catching the wave’, Harvard Business Review, vol. 73, no. 1 (1995), pp. 43–53.
4
1
17
For a discussion of this fundamental question, see the Caux Round Table, an organization of business
leaders which seeks to include moral responsibility within business decisions; www.cauxroundtable.org.
18
A. A. Berle and G. C. Means, The Modern Corporation and Private Property, Macmillan, 1932.
19
R. M. Cyert and J. G. March, A Behavioural Theory of the Firm, Prentice-Hall, 1963.
20
See M. Friedman, Capitalism and Freedom, University of Chicago Press, 1962, p. 133.
21
For a discussion of different value-creation metrics, see G. Arnold, Corporate Financial Management,
Pearson, 2013, chapter 15.
22
R. E. Freeman, Strategic Management: A Stakeholder Approach, Pitman, 1984.
23
A. Mendelow, Proceedings of Second International Conference on Information Systems, Cambridge, 1991,
cited in G. Johnson, K. Scholes, and R. Whittington, Exploring Corporate Strategy: Text and Cases, 7th edn,
Prentice Hall, 2005, pp. 181–2.
24
See E. Sternberg, ‘The defects of stakeholder theory’, Corporate Governance: International Review, vol. 5,
no. 1 (1997), pp. 3–10.
25
‘IKEA unveils plans for its new store in Greenwich’, 17 January 2017, www.ikea.com.
26
E. Sternberg, Corporate Governance: Accountability in the Marketplace, 2nd edn, IEA, 2004.
27
R. D. Buzzell and B. T. Gale, The PIMS Principles: Linking Strategy to Performance, Free Press, 1987.
28
For a discussion of financial metrics, see Arnold, n. 21, chapter 15.
29
R. S. Kaplan and D. P. Norton, ‘The balanced scorecard—measures that drive performance’, Harvard Business
Review, vol. 69, no. 1 (1992), pp. 71–9.
30
See R. S. Kaplan and D. P. Norton, ‘Using the balanced scorecard as a strategic management system’,
Harvard Business Review, vol. 74, no., (1996), pp. 75–85.
31
31 The Guardian, 5 July, 2017, Adam Vaughan.
32
See M. Zairi, Benchmarking for Best Practice—Continuous Learning through Sustainable Innovation,
Butterworth Heinemann, 1996.
113
4
CHAPTER 4 The Internal Environment: Value-Creating Activities
CHAPTER 5
THE INTERNAL ENVIRONMENT: A
RESOURCE-BASED VIEW OF STRATEGY
5.1 The
Resource-Based
View of Strategy
5.2 The VRIO Framework
and Sustainable
Competitive Advantage
5.3 Criticisms of the
Resource-Based
View
5.4 A
Knowledge-based
View of the Firm
5.5
Dynamic Capabilities
Main Reference
D.J. Teece, G. Pisano,
and A. Shuen,
Dynamic capabilities and
strategic management',
Strategic Management
Journal, vol. 18, no. 7
(1997), pp. 509–33.
Learning Objectives
After completing this chapter you should be able to:
●
●
●
●
●
Discuss differential firm performance from a resource-based view
Explain the role of capabilities in achieving competitive advantage
Explain how an understanding of its value chain helps an organization assess its
capabilities
Evaluate the VRIO framework as a means of achieving sustainable competitive
advantage
Evaluate dynamic capabilities as a means of dealing with the limitations of the
resource-based view
CHAPTER 5 The Internal Environment: A Resource-Based View of Strategy
115
Introduction
Chapter 4 was devoted to an analysis of the internal environment and how the organization might usefully analyse
its value-creating activities. In order to help assess the importance of the firm’s internal environment we placed our
discussion in the context of the factors which account for an organization’s performance. In Chapter 3 we saw that the
answer to the question ‘What drives an organization’s performance?’ was rooted in an understanding of an organization’s markets and industry. This ‘positioning approach’ accepts the importance of an organization’s resources, but
argues that in formulating strategy an analysis of the competitive environment is a more appropriate starting point.
What determines an organization’s performance will continue to be our backdrop as we evaluate an alternative
approach to this question. We have already noted that a criticism made about the positioning approach is that it fails
to answer this question adequately. In this chapter, we explore a different perspective, which suggests that relative
firm performance and therefore profitability, is determined by an organization’s resources and capabilities. This has
been termed the resource-based view of the firm.
5
5.1 The Resource-Based View of Strategy
The resource-based view of strategy has a long antecedent, with links stretching back to Edith Penrose in the 1950s.1
However, it is more commonly associated with the work of C. K. Prahalad and Gary Hamel, Richard Rumelt, Jay Barney,
Robert Grant, and Birger Wernerfelt.2 As we will see later, advocates such as David Teece, have sought to introduce a
dynamic element to the theory to overcome some of the inherent criticisms of this framework. The resource-based
view also deals with the competitive environment facing the organization, but takes an ‘inside-out’ approach; its starting point is the organization’s internal environment. As such, it is often seen as an alternative perspective to Porter’s five
forces framework, evaluated in Chapter 3, which takes the industry structure as its starting point, hence ‘outside-in’.
The resource-based view emphasizes the internal capabilities of the organization in formulating strategy to achieve a
sustainable competitive advantage in its markets and industries. If we see the organization as made of resources and
capabilities which can be configured (and reconfigured) to provide it with competitive advantage, then this perspective does indeed become inside-out. In other words, its internal capabilities determine the strategic choices it makes
in competing in its external environment. In some cases, an organization’s capabilities may actually allow it to create
new markets and add value for the consumer, such as Apple’s various i products and Toyota’s hybrid cars. Clearly, where
an organization’s capabilities are seen to be paramount in the creation of competitive advantage it will pay attention
to the configuration of its value-chain activities. This is because it will need to identify the capabilities within its valuechain activities which provide it with competitive advantage.
If we look at Toyota’s much admired manufacturing system, we see it manages inbound logistics in the form of excellent
material and inventory control systems. This ensures that inventory levels are sufficient to meet customer demand by
having parts delivered prior to their assembly. If we look at other primary activities in the value chain, such as operations,
we find automated and efficient plants with embedded quality control systems. This is backed by marketing and sales
through advertising and dealership networks, and service through the use of guarantees and warranties. Toyota’s valuechain activities, its linkages across them, and its linkages with the value chain of its suppliers are configured in such a way
that they provide the Japanese competitor with a core competence or distinctive capability. It is this capability which
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provides it with competitive advantage and which its competitors have found difficult to match. Toyota is also able to
appropriate the added value that is derived from these activities. For instance, Toyota makes more profit than the three
largest automobile companies in the US combined.
5
If firms in an industry face similar industry conditions we might expect these firms, other things being equal, to exhibit
some degree of similarity with respect to profitability. However, if we compare the profitability of Toyota with its rivals
in the automobile industry, we see a divergence in profitability between firms that compete in the same industry.
Porter3 argues that it is the industry structure within which firms compete and how they position themselves against
competitive forces in that structure which determines how profitable individual firms will be. In contrast, the resourcebased view points not to industry structure, but to the unique cluster of resources and capabilities that each firm
possesses.4 Therefore, for proponents of the resource-based school, the answer to why firms within the same industry
experience different levels of performance is found by looking inside the firm.
The resource-based view of strategy is based on two assumptions about the resources and capabilities that each
firm possesses. The first assumption is resource heterogeneity; this implies that different firms competing in the same
industry may possess different resources and capabilities. As a result, a firm competing in a given industry may be
able to undertake activities better than its rivals in the same industry. For example, Toyota’s lean manufacturing and
just-in-time (JIT) delivery of supply parts has enabled it to reduce costs in the production of automobiles. The second
assumption is resource immobility. This implies that the resource and capability differences that exist between firms
may continue over time. The reason being it is too costly for the firms who do not possess these resources and capabilities to develop or acquire them. This helps to explain why some firms consistently outperform other firms; differential
firm performance.5 For example, Dyson’s advantage is the capability and tenacity of its leader, James Dyson, to develop
new technologies, which is used to substantially improve the efficiency of existing household products. Aligned with
the technology is the creation of innovative designs for products, from vacuum cleaners to hair dryers.
As is so often the case, the differences between competing perspectives can be overdone. For example, Raphael Amit
and Paul Schoemaker argue that the resource-based view can be seen as a complement to the positioning school.6
Gary Hamel and C. K. Prahalad concede that Porter’s approach, which embodies the notion of strategic fit, matching
an organization’s resources to the needs of the external environment, is not so much wrong, but more what they refer
to as unbalanced. For many managers, the concept of strategy simply implies pursuing opportunities that fit the company’s resources. Hamel and Prahalad suggest this approach is not wrong, but tends to obscure an approach in which
strategic stretch supplements strategic fit.7 They argue being strategic means creating a chasm between ambition and
resources. In other words, an organization with a relatively small amount of resources, but with big ambitions can
leverage its resources to achieve a greater output for its smaller inputs.
5.1.1 Resources
The resource-based view of competition draws upon the resources and capabilities that reside within an organization,
or that an organization might want to develop, in order to achieve a sustainable competitive advantage. Resources
may be thought of as inputs that enable an organization to carry out its activities. Where organizations in the same
industry have similar resources, but differing performance, we might deduce that they vary in the extent to which they
utilize their resources. Resources in and of themselves confer no value to organizations. It is only when they are put to
some productive use that value follows. Resources can be categorized as tangible or intangible.
CHAPTER 5 The Internal Environment: A Resource-Based View of Strategy
117
Tangible Resources
The total workforce employed and their productive capacity form a tangible human resource. This is often measured
by criteria such as profit or sales per employee, In reality, measurement of employee productivity is difficult and problematic. Human resource processes such as annual reviews rarely capture the full extent of employee endeavour. This
is because the ability to perform well in a role is a function of attitude and motivation rather than formal qualifications.
Indeed, research by Daniel Goleman to determine the personal capabilities that drive outstanding performance suggest that emotional intelligence is more important than technical ability and IQ.8 In assessing resources, the concept of
opportunity cost is helpful to determine whether existing resources can provide further value. In other words, can an
organization’s resources be used more effectively in a different capacity? In addition, can these assets be sweated i.e.
ensuring that the value derived from existing assets is maximized?
Intangible Resources
Intangible resources comprise brand names, patents and copyrights, an organization’s ability to innovate, and reputation. Given intangible resources are more difficult for competitors to identify, it is not surprising their value to the
firm tends to exceed tangible resources. For example, an intangible resource for the marketing group WPP is the creative insight of its founder, Sir Martin Sorrell. His ability to make major acquisitions, taking over some of the oldest and
most prestigious advertising companies in the world, and integrating them profitably into WPP is a capability few
competitors can imitate. Organizations with valuable tacit knowledge built up through their culture, processes, and
employees over time possess an intangible resource which cannot readily be transferred. This is referred to as path
dependency; the unique experiences a firm has acquired to date as a result of its tenure in business.
The reputation or ‘goodwill’ of an organization is increasingly recognized as a valuable intangible asset, which can easily be damaged by ill-thought-out strategies and marketing campaigns. In recent years, the low cost airline, ­Ryanair,
has moved away from controversial statements about customers, focusing instead on improving its website and
customer service.9 Johnson & Johnson’s response to malicious tampering with their Tylenol product (see Chapter 1)
ensures that it consistently remains top of organizations ranked according to their reputation.10
5.1.2 Organizational Capabilities
Whilst the existence of resources is important, resources per se do not confer any benefit on an organization.
These assets need to be deployed in a way that allows them to work together effectively. It is an organization’s
capability that allows it to deploy these resources towards a desired task. Robert Grant distinguishes between
resources and capabilities.11 He sees resources as inputs into the production process. These include items such as
capital equipment, the skills of individual employees, patents, brands, and finance. On their own these resources
5
Tangible resources refer to the physical assets that an organization possesses and can be categorized as physical
resources, financial resources, and human resources. Physical resources include the current state of buildings, technology, materials, and productive capacity. To add value, these physical resources must be capable of responding flexibly to changes in the marketplace. Clearly, organizations with the most up-to-date technology and processes which
­possess the knowledge to exploit their potential will be at an advantage. Its financial resources will include its cash
balances, debtors and creditors, and gearing (debt-to-equity ratio). The extent to which an organization can achieve
an acceptable return on its capital employed will determine the extent to which it can attract outside capital or financial resources. This will be linked to expectations about its future growth.
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are not productive. To be productive requires the cooperation and coordination of a team of resources. A capability is the capacity for a team of resources to perform some task or activity. Therefore, resources are the source of
an organization’s capability. For example, a firm possessing resources such as a fit-for-purpose plant, access to
finance, and trained employees will not bring success in manufacturing; these resources still need to be deployed
towards a desired end.
We can distinguish between threshold capabilities and distinctive capabilities. A threshold capability is necessary for
a firm to be able to compete in the marketplace. In this respect, all competing firms possess threshold capabilities; it is
a prerequisite for competing in the industry. For example, in order to be able to compete in the automobile industry an
organization must possess knowledge about design, engine, and body manufacture. Without this base knowledge, a
firm would simply be unable to compete at all in that industry, irrespective of their resources.
5
Capabilities, in and of themselves, do not confer any competitive advantage for the organization. To achieve competitive advantage an organization must possess distinctive capabilities. A prerequisite for a distinctive capability is that it
must be highly valued by the consumer and difficult for your competitors to imitate. As we will see, where an organization’s distinctive capability resides within the nexus of its value chain—its own interdependent activities and the
linkages within its value chain system—this can be a powerful source of competitive advantage.
There can be a degree of confusion with the different terms that circulate around the resource-based view of strategy.
When examining the literature, we should bear in mind that the terms capability and competence are often used interchangeably, as are distinctive capability and core competence.
Prahalad and Hamel12 argue that the critical task of management is to create an organization capable of creating products that customers need, but have not yet even imagined. To achieve this, management must successfully operate across organizational boundaries rather than focusing on discrete individual strategic business units
(SBUs). They developed the term core competencies to describe the collective learning of individual members
within an organization and their ability to work across organizational boundaries.13 They point out that many major
corporations have had the potential to build up core competencies, but senior management lacked the vision to
see the company other than as a portfolio of discrete businesses. This is what Prahalad and Hamel refer to as the
tyranny of the SBU.14
A core competence is enhanced as it is applied and shared across the organization. For Prahalad and Hamel, competencies are the glue that binds businesses together and spurs new business development. For example, Toyota’s core
competencies derive from its ability to blend core competencies across the whole organization. It may simply be that
the organization has deployed its collection of resources in such a way that allows it to compete more successfully. In
fast fashion, Zara is the classic example of a firm which has achieved core competence in the way it configures its value
chain. Many organizations have tried to emulate Zara’s success, but found their business model less easy to imitate
than might be first thought. That said, these distinctive capabilities or core competencies still need to be protected if
the organization is to appropriate the rewards that derive from their use.
The Japanese motor manufacturer Toyota has achieved a distinctive capability in the production of petrol-andelectric hybrid cars. This in no small measure results from their first-mover advantages. This refers to organizations
that benefit from the learning and experience they acquire as a result of being first in the marketplace. Other motor
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119
manufacturers are placed in the unenviable position of playing ‘catch-up’. Prahalad and Hamel provide three tests that
can be applied to core competencies in an organization.
1. A core competence should provide access to a wide variety of markets. For example, Honda’s distinctive capabilities
in engine design and production have enabled it to compete in markets such as cars, lawnmowers, and powerboats.
2. A core competence should make a significant contribution to the perceived customer benefits of the end
­products. For example, BMW has distinctive capabilities in engineering, which allow it to produce high quality
cars that sell at a premium.
John Kay argues it is the distinctive capabilities of an organization which provide it with competitive advantage.15
An organization’s capabilities are only distinctive when they emanate from a characteristic which other firms do not
have. Furthermore, possessing a distinctive characteristic is a necessary but not sufficient criterion for success; it must
also be sustainable and appropriable. For a distinctive capability to be sustainable it needs to persist over time. To
be appropriable, a distinctive capability needs to benefit the organization which holds it rather than its employees,
its customers, or its competitors. These distinctive capabilities derive from three areas: architecture, reputation, and
innovation.16 These in turn are linked to relationships between an organization and its stakeholders: its employees,
customers, shareholders, and suppliers, as well as a group of collaborating firms to which it may network. It is these
relationships which allow an organization’s resources to provide it with distinctive capabilities through the conduit of
its architecture, reputation, and innovation.
Architecture
An organization’s architecture comprises the system of relational contracts which exist inside and outside the organization. Internal architecture refers to an organization’s relationship with its employees, and the relationship that exists
between employees. External architecture refers to its relationships with its customers and suppliers. In addition,
an organization may engage in relationships with other firms working in related activities; this form of architecture
is referred to as networks. There is a myth about great leaders of organizations which detracts from the reality of
­organizational behaviour. Organizations depend far less on individual leaders and groups than they do on their
­organizational routines.
Organizational capabilities require that the knowledge of individuals is integrated with a firm’s resources such as
its capital equipment and technology. This is accomplished by organizational routines.17 Organizational routines are
regular, predictable, and sequential patterns of work activity undertaken by members of an organization. Therefore,
an organization’s capabilities comprise a number of interacting routines. For a firm’s capabilities to operate effectively
it must achieve cooperation and coordination between routines. It is these organizational routines which develop
over time and are continually used in changing competitive conditions, which allow the organization to get the best
out of their ordinary employees. As Kay states, ‘Architecture does not create extraordinary organizations by collecting
extraordinary people. It does so by enabling very ordinary people to perform in extraordinary ways.’18 For example,
Amazon uses its capability in web development aligned to efficient logistics in warehousing, distribution, and buyer
relationships to produce a vast array of consumer goods at low prices. The resulting convenience for the consumer has
enabled Amazon to achieve superior growth.
5
3. A core competence should be difficult for competitors to imitate. For example, in the US Southwest Airlines’
competitors have found that having similar resources have not enabled them to replicate what makes the airline
so successful. In the UK, competitors of Ryanair have been unable to deconstruct their success.
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Where a distinctive architecture is based upon the output of all employees rather than a few individuals, it allows
the added value created to be more readily appropriated by the organization. For a distinctive architecture to be
sustainable, the relational contracts that an organization enters into must be difficult for its competitors to identify
and imitate. The relationships will inevitably be implicit, complex, and subtle, based in and around the organization.
This lack of formalization inhibits imitation and ensures that architecture remains a source of competitive advantage.
Architecture, then, refers to the ability of the organization to create organizational knowledge which is more than just
the sum of individual employees. It includes an organization’s ability to respond effectively to changes taking place in
its external environment, as well as its exchange of information both within and outside the company.
5
Reputation
Reputation as a source of distinctive capability is important in those markets where consumers can only ascertain
the quality of a product from their long-term experience. An example would include the use of a firm of architects.
A firm’s reputation is built up through its reliable relationships, which take time to nurture and develop. A reputation
for providing high quality products and services can be used to secure repeat business and charge premium prices.
In addition, reputation can be leveraged when entering related markets. For example, Apple uses its brand image to
compete across the consumer electronics industry. Reputation can also be used to help facilitate a more successful
entry into unrelated markets. Richard Branson’s Virgin Group leverages the Virgin brand that has consumer acceptance
to operate in diverse markets from financial services to health clubs.
Innovation
An organization’s ability to innovate successfully is also a source of distinctive capability that is sustainable and appropriable (see Strategy in Focus 5.1). For example, it may produce innovative products such as Apple with its iTunes,
iPad, and iPhones. In a survey of senior executives around the world to find the fifty most innovative companies,
Apple came top for the third year running.19 Apple’s innovation in product design and development is difficult for
competitors to imitate. Apple entered the mobile phone market in 2007 with the introduction of its iPhone, and in
2010 introduced the iPad—its touch-screen computer. Apple continues to update the design and specification of
its most successful product ever, the iPhone, and launched the iPhone 8 in 2017 to mark its 10th anniversary. This
constant innovation and new product development has proved to be a source of sustainable competitive advantage
as competitors struggle to imitate their success.
The competitive advantage that appears to emanate from innovation may actually derive from an organization’s
architecture. An organization may develop innovative processes which are embedded within the routines of the
organization and are therefore difficult for competitors to copy. By seeking patents and copyrights, organizations can
protect innovative products and ensure that they appropriate the value deriving from their use. In hypercompetitive
markets, as we saw in Chapter 3, D’Aveni20 argues for continuous new product development which allows a firm to
stay one step ahead of competitors. The deliberate cannibalization of a successful product by its successor ensures that
the firm is able to appropriate the rewards from its innovations.
In fact, Apple’s iconoclastic co-founder and former CEO, Steve Jobs, was doing both: constantly developing new
products while also seeking to appropriate more of the value from these products. Apple developed its first in-house
microprocessor, the A4, to power their iPad. This, along with its battery technology, allows Apple to control what components go into its products and reduces its dependence on third-party manufacturers. At the same time, Apple also
has its own software—its iWork suite of programmes that are similar to Microsoft Office. This combination of in-house
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hardware and software has the advantage of making Apple’s technology more proprietary, difficult to imitate, and
importantly, allows Apple to appropriate more of the value from its activities. It also allows Apple to blend all these
technologies in a way that no other competitor can. To increase the adoption of Apple’s products, complementary
products such as Microsoft Office, are integrated seamlessly, which enlarges the overall market.
Honda’s future is quietly being forged in a secretive lab in Mountain View, California. From this 35,000-squarefoot office park, Naoki ‘Nick’ Sugimoto, a fifty-five-year-old Honda veteran, searches for the world’s best tech
partners. Two recent projects from Sugimoto’s lab, a car display enhanced with holograms and an ‘optical’
microphone that dramatically improves speech recognition by reading a speaker’s facial vibrations, wowed
crowds of auto and tech enthusiasts at a consumer electronics show.
‘When it comes to creating innovations, doing everything in-house is not the right way’, says Sugimoto,
echoing a new company line. ‘Open collaboration is really the key.’ As if to underscore the point, the world’s
eighth-largest car maker recently announced partnership talks with Waymo, the Alphabet subsidiary formerly
known as Google’s self-driving-car unit. With the exception of Fiat Chrysler, automakers have trodden carefully
around Google, fearful that the tech giant could someday come to dominate their business.
Times are changing for the maker of the Civic, Accord, and CR-V; the company has long been known for
its obsession with solving engineering problems on its own. Since its founding in 1948, Honda has made
motorcycles, cars, lawn mowers, jets, fuel cells, humanoid robots, and just about everything else in-house. But
in a world where cars are rapidly becoming tech gadgets on wheels, Honda’s hallmark masterful mechanical
engineering is no longer sufficient.
To stay competitive, Honda needs to get over its chronic case of ‘not-invented-here’ syndrome, and as
Sugimoto’s lab and the Waymo talks make clear, it is starting to make progress. ‘Honda is willing to pursue win–
win technology cooperation so that we can openly innovate with other companies and at the same time show
our individuality’, says Honda CEO, Takahiro Hachigo.
The stakes couldn’t be higher. The auto industry has entered a new era dominated by technologies like
artificial intelligence (AI), sensors, apps, and car-sharing. As with every other automaker, Honda’s executives
are touting a ‘cooperative mobility ecosystem’, a fleet of vehicles that communicate with their occupants, other
vehicles, and sensors on roads, bridges, and buildings to make travel safer, less congested, and more fun. Nifty,
for sure, but it’s clear the company can’t get there alone. ‘Honda’s core competencies aren’t in these emerging
areas’, says an analyst at AutoPacific, an industry consultancy.
That’s where innovators like Sugimoto come in. The lab’s overarching goal is not blue-sky research, but rather
to put ‘technologies into production as quickly as possible’, says Sugimoto. In 2014, the lab opened a software
studio to work with app makers to integrate new in-car conveniences into Hondas and Acuras. It’s working with
Visa to let cars auto-pay for parking and petrol, and with fast-food chains to allow hungry drivers to place and
pre-pay for orders.
While the Honda Silicon Valley Lab represents a relatively small piece of Honda’s £4.62 billion ($6 bn) global
research and development (R&D) budget, Sugimoto expects its impact to be far-reaching, and not just for
Honda. ‘We don’t claim any exclusivity. We just share the fruits of what we create together’, he says.
But the broader goal is to revitalize a car maker with a history of engineering greatness. Says Sugimoto, ‘The
purpose is to reenergize the original DNA, stimulate the right brain of all Honda people and figure out the right
path to deliver “wow” innovations to our customers.’
Source: Alan Ohnsman, ‘Honda opens its doors’, Forbes, 28 February 2017. Reproduced with permission.
5
STRATEGY IN FOCUS 5.1 Honda’s Search for Innovation
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In an article entitled ‘Strategy and the delusion of grand design’, Kay21 summarizes distinctive capability as the characteristics of a company that either cannot be copied by competitors or can only be copied with great difficulty. As
we have seen, these will include such things as patents and copyrights, a strong brand image, patterns of supplier or
customer relationships, and skills, knowledge, and routines that are often embedded within the organization and
are difficult for a competitor to unravel. It is these distinctive capabilities that are the basis of sustainable competitive
advantage. The task then is to identify and match these distinctive capabilities with the needs of the marketplace.
5
Kay points out a contradiction inherent in the question, ‘How do organizations create distinctive capabilities?’, since if
distinctive capabilities can be replicated they fail to be distinctive capabilities. What is truly irreproducible has three
sources: (1) a market structure that limits entry; (2) a company’s history which by definition will require time to replicate; and (3) tacitness in relationships. Tacitness refers to the routines and behaviours which take place within a firm
which cannot be copied, since the participants themselves are unsure how they work. Tacit knowledge is defined as
knowledge which is highly personal, hard to formalize and, therefore, difficult to communicate to others. Therefore,
organizations would do well to identify what distinctive capabilities they already possess rather than what distinctive
capabilities they would like to have.
For a discussion of distinctive capabilities, visit the online resources and see the Extension Material
for this chapter.
www.oup.com/uk/henry3e/
The key success factors (KSFs), identified in Chapter 2, can be used to identify resources and capabilities. Key success factors are those factors that keep customers loyal and allow the firm to compete successfully in the industry. If
we know what the key success factors in an industry are, we can work backwards to determine which resources and
capabilities allow the firm to meet these success factors. In reality, the capabilities we seek to identify are embedded in
a firm’s value chain. Therefore, value chain analysis, discussed in Chapter 4, is best used to identify these capabilities.
5.2 The VRIO Framework and Sustainable
Competitive Advantage
In order to assess the extent to which a capability may provide an organization with a sustainable competitive advantage, we can make use of the VRIO framework developed by Jay Barney.22 The VRIO framework ask four questions
with reference to a capability’s Value, Rarity, Imitability, and Organization. The answer to these questions also provide
managers with a capability analysis of their organization’s internal strengths and weaknesses. The four questions are
shown in Table 5.1.
5.2.1 Valuable Capabilities
Organizational capabilities can only be a source of competitive advantage or sustainable competitive advantage when
they are valuable. Capabilities are valuable when they enable a firm to exploit an external opportunity and/or neutralize an external threat. The question then arises as to how an organization might assess this. The answer is to identify
any change in the organization’s revenues and costs as a result of using its capabilities. If there is an increase in its
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123
Table 5.1 Questions for the VRIO framework.
V— Value
Do an organization’s capabilities allow it to exploit environmental opportunities and neutralize environmental threats?
R—Rarity
Are capabilities possessed by only a few competitors?
I—Imitability
Are capabilities costly for other organizations to acquire or imitate?
O—Organization
Is the firm organized to allow it to exploit the valuable, rare, and difficult to imitate capabilities it possesses?
A competing organization seeking to build or acquire these capabilities would need to ensure the cost of doing so
does not outweigh the expected revenue. Where a competitor does not possess valuable capabilities it will be at a
competitive disadvantage to firms which do. Environmental models such as Porter’s five forces (discussed in Chapter 3)
and SWOT analysis (discussed in Chapter 4) seek to identify the organization’s resources which can exploit opportunities and/or neutralize threats. The resource-based view goes further in suggesting the additional characteristics these
capabilities must possess if they are to provide sustainable competitive advantage. Clearly, there are links between the
work of Porter and the resource-based view, and differences between the two approaches can be overstated.
Value chain analysis (discussed in Chapter 4), can be used to look at the activities that go to make up a product or service
with a view to ascertaining how much value each activity adds. A firm can look at the interdependent linkages between
activities within the value chain. This helps it to understand the relationship between the way one value activity is performed and the cost or performance of another activity.23 Furthermore, within its value chain system (also discussed in
Chapter 4), a firm can identify activities which create value within its own value chain as well as the value chain of its consumers, suppliers, and distributors. Clearly, if the capability adds no value to consumers the firm will not increase its revenue.
This also explains why firms with similar resources experience different levels of profitability. By understanding the linkages
within its value chain a given firm is able to deploy its resources into a capability while a competing firm lacks this insight.
Managers seeking to develop capabilities should be aware that the value of their capabilities can be market dependent.
For example, the ability of a firm to achieve competitive advantage through its flexibility in responding to a rapidly
changing market will no longer be valuable if the market suddenly becomes stable and unchanging. As the market
context changes, what were once valuable capabilities may no longer be valuable.24
5.2.2 Rarity
If valuable organizational capabilities reside within a large number of competitors or potential competitors then they
cannot be a source of sustainable competitive advantage. The reason is that each competitor would have the potential to exploit those capabilities in the same way.25 For example, once Amazon demonstrated the value of e-books to
readers other publishers quickly followed suit. A valuable capability for implementing a strategy is visionary leadership that provides insight into how markets and products may develop. If this capability is not rare then many
organizations will also be able to formulate and implement the same strategies. The visionary leadership of Jeff Bezos
5
revenues or a decrease in its costs compared to when the capabilities were not being deployed, then the capability is
valuable. For example, when the Swedish furniture firm IKEA develop products with designers this is usually based on a
price for the end consumer. By utilizing wood that grows quickly and in abundance, cheaper manufacturing methods,
and producing in high volumes, IKEA is able to reduce its costs.
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in founding and guiding Amazon is based on his understanding of the Internet, price leadership, and consumer convenience to achieve market dominance. That capabilities are valuable and rare is a necessary but not sufficient
condition for sustainable competitive advantage. Where a firm’s capabilities are valuable but not rare, they provide
competitive parity, not competitive advantage.
5.2.3 Imitability
5
Valuable and rare capabilities provide a means of temporary competitive advantage. If the organization is to achieve
sustainable competitive advantage it is necessary that competing organizations cannot copy these capabilities. Where
valuable and rare capabilities can easily be imitated, competitors will simply compete away an organization’s ability
to generate above-average returns. An example is the dot.com of the 1990s; some of these companies had innovative
ideas and gained a temporary competitive advantage largely by first-mover advantages into the market. Unfortunately, others quickly followed, acquiring the capabilities to imitate their strategies and eroding any lasting value.
Valuable and rare capabilities can provide a source of sustainable competitive advantage when an organization which
does not possess them can only acquire or develop them, at cost disadvantage compared to the firms that do possess
them.
Consider the British manufacturing company, Dyson, which is famous for its vacuum cleaners.26 Its founder, the inventor Sir James Dyson, spends heavily on R&D of new products. He continually innovates across the product range. For
example, eighty per cent of the fifteen million vacuum cleaners it sells worldwide are now battery-powered cordless
models. Dyson uses the technology he developed for its vacuum cleaners across different products. The company
created the Dyson Institute of Technology to address the shortage of engineers and now recruits and trains engineers
in-house. It has taken on this responsibility in order to grow and drive the business forward (see Strategy in Focus 5.2).
STRATEGY IN FOCUS 5.2 Sir James Dyson: a Difficult Man
to Imitate
Inventor Sir James Dyson has no plans to step back
from his namesake business as it reported record
sales and profit. Dyson, who founded the firm famed
for its vacuum cleaners, said he has no plans to move
on in the near future.
‘I have no retirement plan. I’m fully committed to
the business’, said Sir James. ‘There may be a time
they kick me out but I’m very happy designing and
building new products and technology.’
His vow to remain at the helm of the business
came as it posted annual sales up forty-five per
cent to £2.5bn and profits of £631m, a forty-one per
cent rise on the previous year (see Figure 5.1). The
jump in profits came despite the business, which
has delivered Sir James a fortune estimated at £5bn,
investing heavily in R&D of new products.
Eighty per cent of the vacuum cleaners Dyson sells are cordless, like
this Dyson v6 absolute cordless vacuum cleaner. Source: © Keith
Homan/Shutterstock.com
CHAPTER 5 The Internal Environment: A Resource-Based View of Strategy
Turnover grows
45% to £2.51bn
Profits read
£631m
Dyson now employees
8,500 people globally
£2.5bn
£700m
1000
£600m
125
8000
£2.0bn
£500m
6000
£1.5bn
£400m
4000
£300m
£1.0bn
2000
£200m
£0.5bn £1.38bn
2014
£1.74bn
2015
£2.51bn
2016
£100m
£377m
2014
£448m
2015
£631m
2016
0
£377m
2014
£448m
2015
£631m
2016
5
Figure 5.1 Turnover, profit, and employee numbers at Dyson. Source: Reproduced with permission of The Telegraph
Over the past couple of years Dyson has revamped its range, particularly in vacuum cleaners, and in 2016,
eighty per cent of the 15m it sold worldwide were battery-powered cordless models. ‘Considering we were not
making them two years ago that’s a huge turnaround’, said Sir James.
Also helping drive growth was the launch of Dyson’s Supersonic hair dryer, which uses high-speed motor
technology developed for the company’s vacuum cleaners, and was a step into a new sector for the business.
Profits leapt despite Dyson spending about £7m a week on new products and technology and Sir James said
the company plans to move into new sectors where its expertise can be leveraged—but only when the time
is right.
‘We’re looking at more non-domestic products but we are not rushing to do lots of different things’, he said.
‘We are a private company so we can do it when we are ready.’
The company is the UK’s biggest investor in robotics and AI research, which it sees as massive
growth areas. However, Sir James downplayed recent reports that one-third of UK jobs could be taken over
by robots.
‘I hope that robotics means that we need a lot less human cleaners but to design and make robots you need
an army of highly skilled engineers’, he said.
He is a passionate supporter of developing the UK’s engineering base, which is struggling to turn out
enough people with the skills the sector needs. Sir James announced he was starting his own university
at the company’s Wiltshire base to generate the engineers, spending £15m in the first year of the ­
four-year course which will initially have twenty-five students, a number he expects to grow rapidly.
Dyson also bought a 500-acre ex-RAF base to allow it to expand its UK operations, having outgrown its
current site.
Source: Alan Tovery, ‘Sir James Dyson to remain at controls as Dyson reports record results’, The Telegraph, 27 March 2017. © Telegraph Media Group Limited.
Reproduced with permission.
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PART TWO Strategic Analysis
An organization’s capabilities will be difficult to imitate if it embodies unique organizational conditions, causal ambiguity, and social complexity.
Unique Organizational Conditions
An organization may have acquired its capabilities as a result of being in a unique location which enables it to add
value to consumers, which allows it to generate superior returns. The unique location it possesses is a capability that
is difficult to imitate. French wines have long experienced a competitive advantage through the uniqueness of their
climate, soil, terrain, and expertise handed down through generations; this is referred to as terroir. Similarly, a Scottish
whiskey distiller which is located besides a loch with qualities of water which enhances its blend of whiskey has a
capability which is difficult to imitate. These are examples of first-mover advantages.
5
In addition to first-mover advantages, competitors will find it extremely difficult to replicate capabilities that an organization possesses as a result of the path it has followed to arrive at its current position. This is called path dependency.
It is the combination of unique experiences an organization has acquired to date as a result of its tenure in business.
Competitors simply cannot acquire these capabilities on the open market and therefore cannot imitate the firm’s
value-creating strategy.
Causal Ambiguity
Causal ambiguity exists when the link between the capabilities of an organization and its competitive advantage is
not understood, or is only partially understood by competitors. As a result, competitors are unsure as to which capabilities to acquire and, if acquired, how to integrate them within their own value chain system. The capabilities are more
likely to be a source of sustainable competitive advantage when the organization itself is unsure of the exact source
of its competitive advantage. For example, W. L. Gore and Associates (makers of Gore-Tex fabric) has a culture based
on devolved management, which precludes the need for hierarchy, which in turn successfully facilitates innovation
among their employees. Even managers within W. L. Gore would experience great difficulty in trying to explain exactly
how these disparate activities enable the company to compete successfully. This is because, over time, the way managers work together becomes ‘taken-for-granted’ as opposed to being written in a HR company manual.
Social Complexity
Another reason why an organization’s capabilities may be difficult for competitors to imitate is because they may be
based on complex social interactions. These may exist between managers in an organization, in an organization’s
culture, and in its reputation with its suppliers and customers. John Kay refers to this social complexity as an organization’s architecture.27 When it is known how these socially complex resources add value to the firm, there is no causal
ambiguity between the capabilities and competitive advantage of the organization. However, the fact that competitors may know, for example, that the culture within an organization improves efficiency does not mean that they can
readily imitate that culture.
5.2.4 Organization
So far, we have seen that providing a positive answer to questions of value, rarity, and inimitability progressively moves
an organization towards a potential for competitive advantage. We therefore have the necessary but not quite sufficient conditions for sustainable competitive advantage. In order to exploit being in possession of valuable, rare,
and inimitable capabilities a firm must also be sufficiently organized. This requires the use of appropriate formal and
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127
informal management control systems, procedures, and policies. (See Case Example: The Dynamic possibilities of Warren Buffett.) When this organizational support is lacking, any exploitation of the firm’s valuable, rare, and inimitable
capabilities will be sub-optimal. Barney and Hesterly argue where there is a conflict between a firm’s capabilities and
its organization, the organization should be changed. However, once control systems, procedures, and policies are in
place they tend to be quite inflexible. When that happens the firm is unlikely to fully exploit its available capabilities.28
The use of the term sustainability here does not refer to permanence. Rather, it implies that a competitive advantage
will not be competed away because competitors are unable to imitate it. The competitive advantage may indeed be
eroded by structural changes within the industry such that what was once a competitive advantage in one industry setting may not transcend industry changes. It then becomes a weakness or an irrelevance. This has resonance
with the concept of creative destruction, highlighted by economist Joseph Schumpeter, which causes economies to
advance through transformational changes.29
Competitive Implications
for the Firm
Economic Implications
for the Firm
No
Competitive
Disadvantage
The firm is in a loss-making
situation
No
Competitive
Parity
The firm is making an average level of
profit (temporary)
No
Temporary
Competitive
Advantage
The firm is making an above average
level of profit (temporary)
No
Temporary
Competitive
Advantage
The firm is making an above average
level of profit (temporary)
Is the capability…
Valuable?
Yes
Rare?
Yes
Inimitable?
Yes
Exploited by
organization
Yes
Sustainable
Competitive Advantage
Figure 5.2 The VRIO Framework.
The firm is making an above average
level of profit (sustainable)
5
The VRIO framework is summarized in Figure 5.2. This illustrates the four capabilities of valuable, rare, inimitable, and
organization. The table demonstrates the competitive implication of each capability. As can be seen, it is the accumulation of these capabilities which carry the organization closer to sustained competitive advantage. As the organization
passes through each capability stage starting with whether it is valuable, so it achieves a necessary but not sufficient condition for sustainable competitive advantage. It is only when the VRI capabilities are fully met and these are supported by
the organization’s structure and formal and informal management control systems that the capabilities can be exploited.
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PART TWO Strategic Analysis
5.2.5 Make-or-Buy Decision
The recognition of an organization’s core competence or activities that it performs exceptionally well can be the basis
for its decision to provide a product or service itself, or to outsource it. If the organization is to focus on its core competencies as the basis of its sustainable competitive advantage, then the corollary of this is that activities which do
not constitute a core competence for the firm can be given to outside firms who can provide these at a lower cost. This
decision is intrinsically linked with an understanding of the activities contained within the firm’s value chain. And the
extent to which a company wants to be vertically integrated. For example, British Airways recognizes that the provision
of in-flight meals and snacks adds little value to its activities and can be produced cheaper by the market.
The make-or-buy decision, or what is more appropriately termed transaction costs, is discussed in Chapter 8.
5
5.3 Criticisms of the Resource-Based View
Most would agree that the resource-based view of the firm represents a leap forward in strategic management. There
are clear links and complementarity with the work of Michael Porter and the positioning school, and equally sharp
departures. Whether one would go so far as to classify the resource-based view as a new paradigm within strategic
management is a matter of debate. Furthermore, although the resource-based view encourages managers to focus on
strategies for exploiting firm-specific assets, it is not clear how firms might create sustainable competitive advantage.
A common criticism made of the resource-based view is that it says very little on the important issues of how existing
resources and capabilities can develop and change over time. And how new capabilities might be developed.
Danny Miller et al, introduced the term asymmetries to try to explain how an organization might develop its capabilities.30 Asymmetries are hard-to-copy ways in which a firm differs from its rivals and which may ultimately provide
competitive advantage. Asymmetries within an organization might include, for example, its unique experiences, its
value-chain relationships, or its processes and procedures. The idea is that managers identify and build upon these
asymmetries within their organization rather than trying to copy the capabilities of other firms. In doing so, a company
can use its organizational skills to leverage these asymmetries and exploit opportunities in its market environment.
However, this requires that organizations understand the differences between themselves and their rivals, and which
of their identified asymmetries are relevant to the marketplace.
A similar criticism is that the role played by managers within organizations is often assumed to be self-evident and
therefore seldom addressed. In response to this criticism, the VRIO framework was formulated which explicitly recognizes that capabilities need to be exploited by the organization rather than simply being possessed by the firm.
Another criticism is that the resource-based view does not explain how and why certain organizations achieve competitive advantage in rapidly changing and turbulent environments, such as semiconductors and software.31 The
introduction of dynamic capabilities, as we see in Section 5.4, has helped mitigate concerns about the limitations of
the resource-based view in turbulent environments.
Priem and Butler argue that the resource-based view of strategy lacks detail and is therefore difficult for organizations
to implement.32 Furthermore, the resource-based theory is tautological and cannot be tested empirically. In other
words, the valuable, rare, and inimitable capabilities that generate sustained competitive advantage are defined by
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129
their ability to generate sustained competitive advantage, producing a circular argument which cannot be falsified.33
A more detailed road map is required if it is to prove useful to organizations. Finally, we are back in the realm of deliberate strategies (see Chapter 1) with no formal recognition of emergent strategies and the role that these might play.
5.4 A Knowledge-Based View of the Firm
Grant argues that much current thinking about resources and capabilities has been shaped by an interest in
­knowledge management.36 Much of the literature has been dominated by organizational learning. It has exhorted
firms to become learning organizations and offered remedies for teaching smart people how to learn. We say more
on these issues in Chapters 10 and 11. Grant suggests that the single most important contribution of knowledge
management is the recognition that different types of knowledge have different characteristics. We might also add
that, unlike other resources, knowledge tends not to be depleted with use. Furthermore, the leveraging of knowledge
across organizational boundaries is an active pursuit of most corporations in their search for sustainable competitive
advantage. This search can also be achieved by the organization entering into strategic alliances (see Chapter 9).
Ikujiro Nonaka argues the creation of new knowledge always begins with an individual’s personal knowledge, which
is then transformed into organizational knowledge valuable to the company.37 The task of the knowledge-creating
company is to make this personal knowledge available to individuals throughout the organization. For example, a
number of years ago the Japanese corporation, Matsushita Electric Company based in Osaka, was engaged in trying
to develop a bread-making machine. Despite their best efforts they could not get the machine to knead the dough
correctly; the resulting bread had an overbaked crust, while the inside was hardly baked. The product development
team analysed the problem, including comparing x-rays of dough kneaded by the machine and dough kneaded by a
professional baker, but could find no solution.
In the end a software developer, Ikuko Tanaka, came up with a creative solution. The Osaka International Hotel had
a reputation for making the best bread in Osaka. Therefore, Tanaka trained with the hotel’s head baker to study his
kneading technique. She observed that the baker had a distinctive way of stretching the dough. It took a year of
trial and error, working closely with the project’s engineers, before Tanaka came up with product specifications. This
included the addition of special ribs inside the machine which successfully reproduced the baker’s stretching technique and the quality of the bread she had learned to make at the hotel. The result was Matsushita developed a product that in its first year set a record for sales of a new kitchen appliance.
Nonaka uses this example to illustrate two very different types of knowledge. There is explicit knowledge, which
is the product specifications for the bread-making machine. Explicit knowledge is objective and rational and can be
easily communicated and shared, for example, in product specifications, scientific formulas, and manuals. This was the
end product of the bread-making example. The starting point embodies what Nonaka calls tacit knowledge. We noted
5
The knowledge-based view of the firm views the organization as a knowledge-creating entity. This approach argues
that the most important source of a firm’s sustainable competitive advantage is knowledge and the capability to
create and utilize such knowledge.34 This is because the use of knowledge allows a firm to provide new products and
processes. In addition, it also enables a firm to make existing products and services more efficient and effective. The
knowledge-based view of the firm is widely associated with Ikujiro Nonaka and Robert Grant.35
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earlier that tacit knowledge is highly personal, hard to formalize and therefore difficult to communicate to others. This
was the knowledge possessed by the chief baker at the Osaka International Hotel. In contrast with explicit knowledge,
tacit knowledge is deeply rooted in an individual’s commitment to a specific context, for example, a craft or profession.
At the same time, tacit knowledge has an important cognitive dimension. It consists of mental models, beliefs, and
perspectives that are so ingrained we take them for granted and therefore cannot easily articulate them. These implicit
models profoundly shape how we perceive the world around us. And it is because tacit knowledge includes mental
models and beliefs in addition to know-how, that moving from the tacit to the explicit is really a process of articulating
one’s vision of the world—what it is and what it ought to be. Therefore, when employees invent new knowledge, they
are also reinventing themselves and their company.
5
Nonaka and Takeuchi38 argue it is precisely because explicit knowledge is so readily transferred that it requires some form
of protection, such as copyright or patent, if it is to remain within the organization. Tacit knowledge or ‘know-how’, in contrast, cannot be codified. It is highly personal, and difficult to formalize and disseminate to others. It is revealed through its
application and acquired through practice. Transfer of tacit knowledge can be slow, costly, and uncertain. As we have seen,
tacit knowledge will require individuals to coalesce around the provider of that knowledge if it is to be eventually acquired.
In their discussion of the firm as a knowledge-creating entity, Nonaka, Toyama, and Nagata take issue with Grant’s
assertion that knowledge creation is an individual activity, with the organization merely focused on applying its existing knowledge.39 They see this view of knowledge and human beings as ‘static and inhuman’. They argue instead that
knowledge is created through dynamic interactions between and among individuals and their environments, in contrast to an individual acting alone. For Nonaka et al., sustainable competitive advantage is achieved via the firm’s
capability to exploit existing knowledge, and to create new knowledge out of existing knowledge, rather than simply
exploiting existing technologies or knowledge. In their dynamic process of knowledge creation, knowledge is created
through interactions among and between individuals. And in the knowledge-creating firm these interactions cannot
be owned, even by the participants of the interactions.
For the organization, managing knowledge will require an understanding of its characteristics. If organizations are
to learn and grow they need to be able to share tacit knowledge effectively. However, managing this tacit knowledge throughout all areas of the organization is a daunting task. If an organization is to learn in ways that benefit its
performance, individuals and groups within the organization must be willing to modify their behaviour accordingly.
Therefore, the question for organizations is not should we? but how do we?
5.5 Dynamic Capabilities
In order to survive and grow all firms must adapt to and exploit changes in their business environment. At the same
time, firms also need to grasp opportunities and create change. In order to understand why some firms are better at
this than others we need to assess the capabilities within organizations.
The dynamic capabilities framework was initially introduced by David Teece and Gary Pisano.40 Subsequent work by
Teece, Pisano, and Amy Shuen further developed this framework to address the limitations of the resource-based
view.41 Teece, Pisano, and Shuen originally defined dynamic capabilities as, ‘the firm’s ability to integrate, build, and
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131
reconfigure internal and external competences to address rapidly changing environments’.42 In this early definition, the
authors use the term dynamic to denote a capacity for organizations to renew their capabilities in order to achieve a
level of fit with their changing business environment. In fact, Teece and his colleagues assert that dynamic capabilities
are important to sustain firm-level competitive advantage, particularly in high velocity markets. Kathleen Eisenhardt
and Jeffrey Martin refined the original definition of dynamic capabilities, suggesting it involves, ‘the firm’s processes
that use resources . . . to match and even create market change’.43 But they also note that dynamic capabilities can operate in moderate environments as well as rapidly changing ones. Given that different authors often use different terms
to make a similar point it is helpful to define the terminology associated with the dynamic capabilities framework.
For Helfat and colleagues, when an organization has a capacity, this implies that the organization is able to perform a
particular activity in a reliable and minimally satisfactory manner.45 Indeed, the use of the term purposefully in the definition is to deliberately convey some degree of intent, even if these intentions are not fully explicit. This is to differentiate
dynamic capabilities from organizational routines which consist of rote activities that lack intent. For example, if we
refer to the capability to manufacture a car, we mean the specific and intended purpose to make a functioning automobile.46 It also differentiates dynamic capabilities from an accidental outcome or chance.
Interestingly, the use of ‘intent’ is flexible enough to allow for emergent activities, for example actions undertaken by
middle managers without the explicit instruction of the board of directors.47 To perform a particular activity simply
means to undertake or carry out the activity. This refers to substantive activity with serious consequences for financial
performance. A capability enables the repeated, reliable performance of an activity that implies a pattern or practised
element, in contrast to ad hoc activities. This is part of an organization’s acquired experience or path dependency
rather than the skill of a single individual. And the phrase minimally satisfactory manner can be taken to mean that the
output of an activity functions at least minimally as intended.
Helfat and her colleagues make a distinction between operational capabilities and dynamic capabilities.48 Operational
capabilities allow an organization to make a living in the present. In other words, an operational capability maintains
the status quo within the firm. The firm undertakes activities on an on-going basis using the same techniques to support its existing products and services for the same consumers. Other academics refer to operational capabilities as
zero-order capabilities.49
Dynamic capabilities, in contrast, are concerned with change, and enable a firm to extend or modify how it currently
makes a living. Dynamic capabilities come in many forms; some allow an organization to develop new products and
production processes. Other dynamic capabilities allow an organization to undertake acquisitions and strategic alliances. Still others involve the capabilities of managers in delivering profitable growth and change. In addition, there
is the management and organizational processes which are an integral part of capabilities and help an organization to
identify and respond to the need for change. This is because the extent to which dynamic capabilities fit with the internal
and external environment will determine their ability to extend or modify their existing business environment. Teece
refers to the capability to sense and shape opportunities and threats as well as the capability to seize opportunities.50
5
Constance Helfat and her colleagues consider that to survive and prosper in a changing environment organizations
have to develop dynamic capabilities. They define dynamic capabilities as ‘the capacity of an organisation to purposefully create, extend, and modify its resource base’.44 This definition states that, irrespective of its ultimate effect, the action
of dynamic capabilities is foremost on the firm’s resource base.
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PART TWO Strategic Analysis
Sidney Winter contends that the value of dynamic capabilities is not endorsed by all strategy scholars.51 While some
may view dynamic capabilities as a source of competitive advantage, others remain sceptical about their existence.
Others argue that they have merit, but not necessarily to confer competitive advantage, whilst others doubt the efforts
to strengthen such capabilities are a genuine option for managers in industry.
5
In reality, Helfat and Winter argue that the distinction between dynamic and operational capabilities is actually difficult to define for three reasons.52
1) Change is always occurring to some extent.
It is often said there are only two certainties in life: death and taxes. However, it would be more accurate to also
include a third certainty; change. A conundrum is that if everything is always changing then how can we discuss
or even consider things that don’t change? Clearly, if we cannot make a distinction between things that change
and those that do not change then any distinction between dynamic and operational capabilities become
­problematic. A possible solution is to view change in the context of one’s own perspective. For instance, when you
view something close up you are more likely to observe change than when you view from a distance. In the same
way, an organization viewed at a high level of abstraction may appear to exhibit no change in its capabilities. But
a detailed look inside the organization may reveal changes in the features of a capability which are not visible
from a distance. Therefore, what appears as no change from a distance obscures more granular change close up.
Another solution to the dilemma of constant change is the time period over which one assesses change. This is
because incremental change is difficult to perceive whereas the summation of such change is readily observable.
For example, the development of wireless telephony took many years before it eventually became a new communication technology. A view of wireless telephony at any one moment in time would not review the magnitude of
the change taking place.
2) The blurring of the boundary between radical versus non-radical change.
There is a presumption that unless a capability causes a radical change in how a company makes a living, it
is not dynamic. However, because a radical change can be difficult to define, this may not be a particularly
helpful definition for a dynamic capability. For example, in the oil industry, oil reserves start to diminish as
soon as production begins which means new oil reserves have to continually be found. This oil replenishment capability when viewed from a distance may appear as more of the same activity the organization has
always undertaken and therefore an operational capability. In reality, the capability is dynamic since it allows
the organization to repeatedly augment its assets by discovering new and different geological formations
that contain oil. Therefore, just because a capability may not generate a perceived radical shift short-term
does not preclude it from being dynamic, since large amounts of change may be apparent when viewed over
the long run.
3) Some capabilities can be used for both operational and dynamic purposes.
It can be difficult to draw a distinction between dynamic and operational capabilities, particularly when a given
capability can be used for both dynamic and operational purposes. For example, in the consumer group Procter
& Gamble, a brand manager may have responsibility for promoting established as well as new brands. Yet the
manager will utilize the same organization routines and processes for new and existing products. This implies
brand management can be an operational and a dynamic capability.
One reason for the plethora of confusion that still resides within the dynamic capabilities framework is that key
participants remain divided on crucial conceptual issues. There appears to be a divide between the two seminal
papers in this field on how dynamic capabilities can help organizations to achieve and sustain competitive advantage. This refers to the original work by Teece et al.53 and subsequent revisions by Eisenhardt and Martin.54 Margaret
Peteraf and her colleagues refer to this difference as ‘the elephant in the room of research on dynamic capabilities’.55
That we have two contradictory positions for the dynamic capabilities framework’s core elements is not seen as a
cause for concern, but only because the framework is still developing. What these authors suggest is that by using a
contingency-based approach it may be possible to unify the research on dynamic capabilities while also maintaining the assumptions that led to their differences.
Teece is less sanguine on this matter, arguing that Eisenhardt and Martin’s work represents a re-conceptualization
of dynamic capabilities.56 The effect of which is to compromise crucial elements in Teece and his colleagues’ original
formulation of dynamic capabilities. Furthermore, when you look at rapidly changing or high-velocity markets,
conceptual differences between the key protagonists are apparent. For example, Teece and his colleagues consider
dynamic capabilities important for sustainable firm-level competitive advantage, especially in high-velocity markets. In contrast, Eisenhardt and Martin argue dynamic capabilities are unsuited to creating sustainable competitive
advantage and are likely to break down in high-velocity markets. They point to the emotional inability of managers
to cope with uncertainty in high-velocity markets.
Their conception views dynamic capabilities as organizational processes, such as product development
routines, alliance and acquisition capabilities, and resource allocation routines. These processes of dynamic capabilities are limited to simple rules that are less stable than fixed routines and likely to collapse in high-velocity
environments. Their claim that all dynamic capabilities can be captured as best practice is problematic, Since if
dynamic capabilities can be captured as best practice they can be imitated by rivals and cannot, therefore, be a
source of competitive advantage.
For Teece, the issue may simply be that Eisenhardt and Martin are dealing with a different class of capability; an
ordinary capability. Such capabilities can be captured as best practice and would be subject to imitation. Whereas
for Teece, what constitutes replicable best practice within an organization is not likely to constitute a dynamic
capability. Another point of departure between these two approaches to dynamic capabilities is the role of
managers. Within the Teecian framework managerial action complements organizational routines, since dynamic
capabilities involve a combination of organizational routines and entrepreneurial leadership. Hence Teece rejects
the notion that dynamic capabilities can only reside in high-level routines. Indeed, reintroducing the one-time
actions of entrepreneurs/managers as a component of dynamic capabilities provides relevance in high-velocity
environments.57
Although there is confusion over terminology and conceptualization, the dynamic capabilities framework
does offer a relevant perspective for assessing differential firm performance. There is still more work to do on
research if a conceptual framework is to be unified and accepted by proponents. Much of the research is often
disconnected and pointing in different directions. What is required is a consolidation of the main principles and
to capitalize on past research in a more focused way.58 That said, the proliferation of recent journal articles on the
resource-based view and dynamic capabilities is testimony to their enduring appeal.
Summary
The resource-based view has shaken up strategic management by questioning industry selection and positioning
which results in organizations pursuing similar strategies. Instead, this approach emphasizes the organization’s own
set of resources and capabilities as a determinant of competitive advantage.
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PART TWO Strategic Analysis
5
In this chapter, we have explored resources and capabilities in order to identify how competitive advantage might be
achieved. We have also addressed the issue of sustainable competitive advantage. There is slight confusion among the
terms used by different adherents to the resource-based view but, as we have seen, this is readily overcome. Where
Prahalad and Hamel discuss core competence, Kay uses the term distinctive capabilities, while Grant distinguishes
between resources and capabilities. Each term refers to a means of achieving sustainable competitive advantage
although the generic term capabilities now seems to proliferate within the literature. We examined Barney’s VRIO
framework which evaluates four attributes an organization’s capabilities must possess in order to provide it with the
potential for sustainable competitive advantage: (1) it must be valuable; (2) it must be rare; (3) it must be difficult to
imitate; and (4) the organization should possess the structure and management systems to support the capabilities in
a manner which facilitates their exploitation.
We discussed criticisms of the resource-based view as a static and equilibrium-based model which provides challenges for organizations trying to implement this approach in changing environments. A knowledge-based view
of the firm was considered as a possible source of competitive advantage. The dynamic capabilities framework was
evaluated as a means of dealing with the static limitations of the resource-based view. We considered the on-going
debate between key protagonists in the field concerning the nature of dynamic capabilities and its definition, and the
effects and consequences of dynamic capabilities. Whilst there is movement towards a unified framework, until this is
accomplished it is likely it will impede progress both conceptually and empirically.
We end by arguing that Porter’s industry analysis remains important and the choice should not be seen as one of
either/or, but rather one of complementarity. Organizations cannot neglect the industries within which they operate
but neither can they afford to focus slavishly upon them at the expense of their internal resources and capabilities and
miss opportunities to establish sustainable competitive advantage.
CASE EXAMPLE The Dynamic Capabilities of Warren Buffett
Warren Buffett is CEO and chairman of Berkshire Hathaway;
a diversified conglomerate which he runs with his long-time
associate and friend, Charley Munger. Munger serves as vice
chairman, and is six years Buffett’s senior. Berkshire, as the conglomerate is commonly called, is based in Omaha, Nebraska.
There, the similarity with any other company ends.
In his office in Omaha, Buffett displays only one certificate
of his education. Despite having a degree in economics from
Columbia Business School it is a certificate for something more Warren Buffett, Chairman/CEO of Berkshire
mundane, for completing the ‘Dale Carnegie Course in Effec- Hathaway. Source: © Krista Kennell/Shutterstock.com
tive Speaking, Leadership Training, and the Art of Winning
Friends and Influencing people’. It is dated 23 January 1952.
More than fifty years ago, Warren Buffett began investing the money of residents in his home town of Omaha.
Few could have imagined back in 1956 that this scruffy young man would make them fabulously wealthy. Over
time, he would gradually shift from a company obtaining most of its gains from investment activities to one that
grows in value by owning businesses. One of these businesses was a worthless textile mill called Berkshire Hathaway, which was eventually closed. Nowadays, the company’s annual meeting attracts around 40,000 shareholders. Buffett and Munger spend five hours answering questions from shareholders, journalists, and analysts.
In an age when diversified conglomerates are out of fashion, Berkshire’s gain in net worth during 2016 was a
phenomenal $27.5 billion. Berkshire owns more than sixty companies, including GEICO insurance, BSNF, a rail
group, and Mid-American Energy, a utility company. Berkshire acquired Kraft Heinz, which it co-owns with 3G,
a buyout fund. Its portfolio of investments includes large shareholdings in mainly American companies such
as Coca-Cola, Wells Fargo, IBM, American Express, and recently Apple. Buffett first bought Apple stock in early
2016. The purchase marked a shift in strategy for the investor, who has steered clear of technology stocks; he
doesn’t even own a smartphone.
His insurance businesses, with premiums paid up front and claims paid later, provide a ‘float’ for which to fund
his investments. Assuming the risks are priced correctly when an insurance policy is written, the revenue generated is free cash. Buffett is keen to perpetuate the culture and character Hathaway embodies. A fellow board
member is Bill Gates. In 2006, Buffett donated Berkshire Hathaway shares worth over $30 billion to the Bill and
Melinda Gates Foundation, the biggest single charitable donation in history. The charitable Foundation has only
three trustees; Bill and Melinda Gates, and Warren Buffett.
After his death, he intends his vast wealth to be given away. That said, he purports to be in excellent health
on his regular diet of Cherry Coke and hamburgers. He plays the ukulele and bridge. The one exception to his
humble lifestyle is a corporate jet, which is second-hand and named ‘The Indefensible’. This brings up the oftenavoided question of succession.
In 2017, Warren Buffett and Charlie Munger were aged
eighty-six and ninety-three, respectively. The partnership
between the two men is one of mutual respect and admiration. As Munger puts it, they ‘don’t agree totally on everything,
and yet we’re quite respectful of one another’. Buffett points
out that whenever they do disagree, Charlie says, ‘Well, you’ll
end up agreeing with me because you’re smart and I’m right.’
Buffett’s role is to deliver significant growth to shareholders over time. He has only two jobs, ‘to attract and keep out- Charlie Munger, vice president of Berkshire
standing managers to run our various operations. The other Hathaway. Source: © Kent Sievers/Shutterstock.com
is capital allocation.’ Over the past fifty-two years Berkshire’s
per-share book value has grown from $19 to $172,108, a rate of nineteen per cent compounded annually. In
contrast to other companies, Berkshire directors retain all earnings, paying no dividends. This reflects the belief
that they can earn a greater return on capital by investing shareholder funds.
The Sage of Omaha, as Buffett is commonly called, is renowned for taking the right financial decisions. In the
late 1990s Buffett warned against the excesses of the dotcom boom. While financial analysts were busy talking
of a new investment paradigm he quietly avoided all the new start-up companies he did not understand. From
1998 to 2000 Berkshire Hathaway’s share price fell by forty-four per cent; at the same time the stock market rose
by thirty-two per cent. When these ‘new economy’ companies went bankrupt after the bubble burst, sticking
to his principles paid off.
Prior to the financial collapse of 2007–08, he described derivatives as ‘financial weapons of mass destruction’,
the very derivatives on which Lehman Bros and investment banks depended to turbo-charge their profitability
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CHAPTER 5 The Internal Environment: A Resource-Based View of Strategy
5
136
PART TWO Strategic Analysis
prior to their collapse. It was Warren Buffett’s reputation which allowed him to take a shareholding in Goldman
Sachs and GE on advantageous terms during the financial crisis, which proved hugely profitable. In 2017 Forbes
estimated his net worth at $75.6 billion, making him the second richest man in the world after Bill Gates.
Berkshire’s portfolio of shares and bonds has continued to grow and to deliver substantive capital gains,
interest, and dividends. If he can acquire a company’s shares when they are cheap, as he did with Coca-Cola
after the ‘new Coke’ fiasco, he will. But as Buffett puts it, ‘it’s far better to buy a wonderful company at a fair price
than a fair company at a wonderful price’. The portfolio earnings have provided major support in financing the
purchase of businesses.
There has occurred a gradual shift from a company obtaining most of its gains from investment activities to
one that grows in value by owning businesses. By the early 1990s, the focus was changing from financial investments to the outright ownership of businesses.
Buffett believes his unconventional, two-pronged approach to capital allocation provides him with a real
edge. By 2016, investment in shares comprised only one-fifth of Berkshire’s assets.
Berkshire Hathaway is a closed-end fund, where shares can be redeemed by selling to another investor,
unlike the open-ended funds, favoured by the European Union, which tends to constrain long-term investments. Buffett avoids the financial engineering and creative accounting prevalent among other conglomerates
whose professed strength is transferable management capabilities.
His successful formula is to buy quality companies he understands with good defences against competitors.
He trusts managers to run them as before, and retains them for the long term. His continued success is contrary
to the efficient market hypothesis. This states that, over the long term, the current market price always reflects all
available and relevant information about a company. This implies that over the long term you cannot outperform the market, which Buffett consistently does. His choice of acquisitions includes companies with advantage
over their competitors that are hard to replicate. This might be a popular brand or companies with some degree
of monopoly power; often in mature industries. He admires companies with a strong ethical culture, with managers whose focus is performing a good job rather than making money.
As for Berkshire, a major problem it faces is that its prospective returns fall as its assets increase. That said,
Berkshire Hathaway trades at around forty per cent over its book value, evidence that conglomerates can add
rather than destroy the value of the companies they own. As Andrew Campbell, co-author of ‘Strategy for the
Corporate Level’ states, ‘no other firm in the past 100 years has been able to do consistently what Berkshire
Hathaway has done’.
Questions
1. What are the dynamic capabilities which Warren Buffett possesses?
2. Why do you think no organization has copied Berkshire Hathaway’s relatively simple business model?
3. How will Berkshire Hathaway survive the loss of Warren Buffett and Charlie Munger?
Sources: ‘Playing out the last time’, The Economist, 1 May 2014; ‘Life after Warren’, The Economist, 26 April 2014; ‘A sage that knows his onions’, The Economist, 16
October 2008; ‘Warren Buffett’, The Economist, 18 December 2008; ‘$1 billion stakes on the menu’, The Economist, 21 May 2016; Berkshire Hathaway http://www.
berkshirehathaway.com; Forbes Media https://www.forbes.com; John Kay, ‘Berkshire’s business model is simple and effective, yet rarely copied’, Financial
Times, 4 May 2016.
CHAPTER 5 The Internal Environment: A Resource-Based View of Strategy
137
Review Questions
1. Evaluate the key differences between Porter’s five forces framework and the resource-based view of competition.
2. What do you believe is the contribution of dynamic capabilities to strategic management?
Discussion Questions
1. The pursuit of dynamic capabilities requires a unique organizational culture. Discuss.
2. It always better to make a product or deliver a service in-house rather than leave it to the market. Discuss.
Research Topic
5
Identify the capabilities that reside within India’s Tata Group. Evaluate the extent to which these provide the group
with competitive advantage.
Recommended Reading
A good introduction to the resource-based view is provided by:
●
J. Barney, ‘Firm resources and sustained competitive advantage’, Journal of Management, vol. 17, no. 1 (1991),
pp. 99–120.
An article that is widely credited with popularizing the views of the resource-based approach is:
●
C. K. Prahalad and G. Hamel, ‘The core competence of the organization’, Harvard Business Review, vol. 68,
no. 3 (1990), pp. 79–91.
For a seminal introduction to the discipline of dynamic capabilities, see:
●
D. J. Teece, G. Pisano, and A. Shuen, ‘Dynamic capabilities and strategic management’, Strategic
Management Journal, vol. 18, no. 7 (1997), pp. 509–33.
For an informative discussion of distinctive capabilities, see:
●
J. Kay, Foundations of Corporate Success, Oxford University Press, 1993.
www.oup.com/uk/henry3e/
Visit the online resources that accompany this book for activities and more information on the internal
environment.
138
PART TWO Strategic Analysis
5
References and Notes
1
E. T. Penrose, The Theory of the Growth of the Firm, John Wiley & Sons, 1959.
2
C. K. Prahalad and G. Hamel, ‘The core competence of the corporation’, Harvard Business Review, vol. 68, no. 3
(1990), pp. 79–91; R. P. Rumelt, ‘How much does industry matter?’, Strategic Management Journal, vol. 12, no. 3
(1991), pp. 167–85; J. Barney, ‘Firm resources and sustained competitive advantage’, Journal of Management,
vol. 17, no. 1 (1991), pp. 99–120; R. Grant, ‘The resource-based theory of competitive advantage: implications
for strategy formulation’, California Management Review, vol. 33, no. 3 (1991), pp. 114–35; B. Wernerfelt,
‘A resource-based view of the firm’, Strategic Management Journal, vol. 5 (1984), pp. 171–80.
3
M. E. Porter, Competitive Strategy, Free Press, 1980.
4
D. J. Collis and C. A. Montgomery, ‘Competing on resources: strategy in the 1990s’, Harvard Business Review,
vol. 73, no. 4 (1995), pp. 118–28; G. Stalk, P. Evans, and L. E. Schulman, ‘Competing on capabilities: the new
rules of corporate strategy’, Harvard Business Review, vol. 70, no. 2 (1992), pp. 57–69.
5
See J. B. Barney, ‘Resource-based theories of competitive advantage: a ten-year retrospective on the
resource-based view’, Journal of Management, vol. 27 (2001), pp. 643–50.
6
R. Amit and P. J. H. Schoemaker, ‘Strategic assets and organizational rents’, Strategic Management Journal,
vol. 14, no. 1 (1993), pp. 33–46.
7
G. Hamel and C. K. Prahalad, ‘Strategy as stretch and leverage’, Harvard Business Review, vol. 71, no. 2 (1993),
pp. 75–84.
8
D. Goleman, ‘What makes a leader?’, Harvard Business Review, vol. 76, no. 6 (1998), pp. 93–102.
9
Gwyn Topham, ‘Fewer rules, less hassle, more profit—how being nice paid off at Ryanair’, The Guardian, 30
May 2015.
10
See www.harrisinteractive.com for a list of companies and their reputation quotient (the Reputation Index).
11
Grant, n. 2.
12
Prahalad and Hamel, n. 2.
13
Prahalad and Hamel’s use of the term core competence is nowadays used less in the literature, as capability
has become the dominant term.
14
See Prahalad and Hamel, n. 2.
15
J. Kay, Foundations of Corporate Success, Oxford University Press, 1993.
16
For a detailed discussion of the role architecture, reputation, and innovation in achieving distinctive
capability, see Kay, n. 15, chapters 5, 6, and 7.
17
R. R. Nelson and S. G. Winter, An Evolutionary Theory of Economic Change, Harvard University Press, 1982.
18
See Kay, n. 15, p. 69.
19
See ‘The 50 most innovative companies’, Business Week, 3 May 2007 (available online at:
www.businessweek.com).
20
R. A. D’Aveni, ‘Strategic supremacy through disruption and dominance’, Sloan Management Review, vol. 40,
no. 3 (1999), pp. 117–35.
21
J. Kay, ‘Strategy and the delusion of grand design’, in Mastering Strategy, Pearson Education, 2000, pp. 5–10.
22
In Barney’s initial article, see Barney (n. 2), the framework for assessing capabilities was VRIN, where N stood for
no strategic substitute. This has evolved into VRIO where O represents organization. The question now
CHAPTER 5 The Internal Environment: A Resource-Based View of Strategy
139
23
M. E. Porter, Competitive Advantage, Free Press, 1985.
24
See J. B. Barney, M. Wright, and D. Ketchen Jr, ‘The resource based view of the firm: ten years after 1991’,
Journal of Management, vol. 27 (2001), pp. 625–41.
25
For a discussion of the conditions that make a resource valuable to a firm before a decision is actually made
on whether to acquire or build it, see J. Schmidt and T. Keil, ‘What makes a resource valuable? Identifying the
drivers of firm-idiosyncratic resource value’, Academy of Management Review, vol. 38, no. 2 (2013), pp. 206–28.
26
A. Tovey, ‘Sir James Dyson to remain at controls as Dyson reports record results’, The Telegraph,
27 March 2017.
27
For a discussion of architecture, see Kay, n. 15, chapter 5.
28
See J. B. Barney and W. S. Hesterly, Strategic Management and Competitive Advantage, Pearson, 2015.
29
The term creative destruction was coined by Austrian economist, Joseph Schumpeter. In his discussion
of the opening up of new markets and organizational development, Schumpeter refers to a process ‘. . .
that incessantly revolutionizes the economic structure from within, incessantly destroying the old one,
incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.’
J. A. Schumpeter, Capitalism, Socialism, and Democracy, Harper and Row, 1942, p. 83.
30
D. Miller, R. Eisenstat, and N. Foote, ‘Strategy from the inside out: building capability creating organisations’,
Californian Management Review, vol. 44, no. 3 (2002), pp. 37–54.
31
See D. J. Teece, G. Pisano, and A. Shuen, ‘Dynamic capabilities and strategic management’, Strategic
Management Journal, vol. 18, no. 7 (1997), pp. 509–33; E. Cavusgil, S. H. Seggie, and M. B. Talay, ‘Dynamic
capabilities view: foundations and research agenda’, Journal of Marketing Theory and Practice, vol. 15, no. 2
(2007), pp. 159–66.
32
R. Priem and J. Butler, ‘Is the resource based view a useful perspective for strategic management research?’,
Academy of Management Review, vol. 26, no. 1 (2001a), pp. 22–40.
33
R. Priem and J. Butler, ‘Tautology in the resource-based view and the implications of externally determined
resource value: further comments’, Academy of Management Review, vol. 26, no. 1 (2001b), pp. 57–66;
I. V. Kozlenkova, S. A. Samaha, and R. W. Palmatier, ‘Resource-based theory in marketing’, Journal of the
Academy of Marketing Science, vol. 42 (2014), pp. 1–21.
34
See I. Nonaka, R. Toyama, and A. Nagata, ‘A firm as a knowledge-creating entity: a new perspective on the
theory of the firm’, Industrial and Corporate Change, vol. 9, no. 1 (2000), pp. 1–20.
35
I. Nonaka, ‘The knowledge creating company’, Harvard Business Review, November–December , vol. 69,
(1991), pp. 96–104. See also I. Nonaka and H. Takeuchi, The Knowledge-creating Company, Oxford University
Press, 1995; R. M. Grant, ‘Towards a knowledge-based theory of the firm’, Strategic Management Journal, vol.
17 (Winter Special Issue, 1996), pp. 109–22.
36
R. M. Grant, Contemporary Strategy Analysis, 5th edn, Blackwell, 2005.
37
Nonaka, n. 35.
38
Nonaka and Takeuchi, n. 35.
39
See Nonaka, Toyama, and Nagata, n. 34.
40
D. J. Teece and G. Pisano, ‘The dynamic capabilities of firms: an introduction’, Industrial and Corporate
Change, vol. 3, no. 3 (1994), pp. 537–56.
5
becomes to what extent the firm is organized to exploit the capabilities of value, rarity, and imitability.
See J. B. Barney, Gaining and Sustaining Competitive Advantage, Addison-Wesley, 1997.
5
140
PART TWO Strategic Analysis
41
See Teece, Pisano, and Shuen, n. 31.
42
See Teece, Pisano, and Shuen, n. 31, p. 516.
43
K. M. Eisenhardt and J. A. Martin, ‘Dynamic capabilities: what are they?’, Strategic Management Journal,
vol. 21, no. 5 (2000), pp. 1105–21.
44
C. E. Helfat, S. Finklestein, W. Mitchell, M. A. Peteraf, H. Singh, D. J. Teece, and S. Winter, Dynamic
Capabilities, Blackwell, 2007.
45
See Helfat et al., n. 44.
46
For a discussion of the different terms surrounding dynamic capabilities and the confusion this may
cause, see C. E. Helfat and S. Winter, ‘Untangling dynamic and operational capabilities: strategy for the
(n)ever-changing world’, Strategic Management Journal, vol. 32, no. 11 (2011), pp. 1243–50.
47
See H. A. Mintzberg and J. A. Waters, ‘Of strategies, deliberate and emergent’, Strategic Management Journal,
vol. 6, no. 3 (1985), pp. 257–72.
48
See Helfat et al., n. 44; also Helfat and Winter, n. 46.
49
Helfat and Winter, n. 46.
50
D. J. Teece, ‘Explicating dynamic capabilities: the nature and microfoundations of (sustainable) enterprise
performance’, Strategic Management Journal, vol. 28, no.13 (2007), pp. 1319–50.
51
S. Winter, ‘Understanding dynamic capabilities’, Strategic Management Journal, vol. 24, no. 10 (2003),
pp. 991–5.
52
See Helfat and Winter, n. 46.
53
See Teece, Pisano, and Shuen, n. 31, pp. 509–33.
54
See Eisenhardt and Martin, n. 43.
55
M. Peteraf, G. Stefano, and G. Verona, ‘The elephant in the room of dynamic capabilities: bringing two
diverging conversations together’, Strategic Management Journal, vol. 34, no. 12 (2013), pp. 1389–410.
56
D. J. Teece, ‘The foundations of enterprise performance: dynamic and ordinary capabilities in an (economic)
theory of firms’, Academy of Management, vol. 28, no. 4 (2014), pp.328–52.
57
See Teece, n. 56.
58
I. Barreto, ‘Dynamic capabilities: a review of past research and an agenda for the future’, Journal of
Management, vol. 36, no. 1 (2010), pp. 256–80.
PART THREE
STRATEGY
FORMULATION
6 Business Strategy
143
7 Corporate Strategy
174
8 International Strategy
205
CHAPTER 6
BUSINESS STRATEGY
6.1 What is
BusinessLevel Strategy?
6.2 Generic
Competitive
Strategies
Main Reference
Porter, M.E. (1980).
Competitive Strategy:
Techniques for
Analysing Industries
and Competitors.
Free Press, New York.
6.3 A Resource-Based
Approach to
Strategy Formulation
Main Reference
Grant, R.M. (1991).
The resource-based
theory of competitive
advantage: implications
for strategy
formulation. California
Management Review,
33(Spring), 114–35.
6.4 Blue
Ocean Strategy
6.5 Strategy
Formulation in
Turbulent Markets
Extension Material
Blue ocean strategies
W.C. Kim and
R. Mauborgne,
Blue Ocean Strategy,
Harvard Business
Press (2005).
Learning Objectives
After completing this chapter you should be able to:
●
●
●
●
●
Discuss the role of business strategy
Evaluate Michael Porter’s generic strategies
Discuss a resource-based approach to strategy formulation
Identify and explain blue ocean strategy
Assess strategy formulation for turbulent markets and disruptive innovation
6.6 Disruptive
Innovation and
Strategy Formulation
C. M. Christensen,
M. E. Raynor,
and R. McDonald,
‘What is disruptive
innovation?’,
Harvard Business
Review, vol. 93,
no. 12 (2015), pp. 44–53.
144
PART THREE Strategy Formulation
Introduction
In exploring strategy analysis, we discussed different analytical tools to help organizations evaluate their macro
and competitive environment. Analytical tools and frameworks which can be used to better understand the macro
environment include PEST analysis and scenario planning. A key task for the strategist is to identify the weak signals
in the macro-environment that have the potential to disrupt an industry’s structure (see Chapter 2). In Chapter 3
we evaluated the industry using Porter’s five forces framework and the industry life cycle. Chapter 4 was devoted to
an analysis of the internal environment, how an organization might usefully analyse its value-creating activities, and
ways in which an organization can assess its performance. Chapter 5 explored a different perspective of competitive
advantage, which suggests that relative firm performance is determined by an organization’s resources and capabilities.
This is the resource-based view and dynamic capabilities.
6
Although the chapters on strategy formulation are separate from those on implementation for ease of exposition, in
reality an organization must be mindful of its ability to implement strategy. Strategy is best viewed as a non-linear,
incremental process in which persuasion is as important as rationally formulated plans.1 Strategy formulation implies
a deliberate form of decision making, but the strategy actually being pursued may be as a result of deliberate and
emergent factors.2 In reality, strategy formulation will derive from the objectives and mission that the organization has
set itself. This was discussed in detail in Chapter 1.
In this and subsequent chapters we address strategy formulation at the business, corporate, and global levels.
6.1 What is Business Strategy?
Any given organization may comprise a number of different businesses, each operating in distinct markets and serving
different customers. A market is defined by demand conditions and based on an organization’s customers and potential customers. The industry in which it competes is determined by supply conditions such as a common technology or
distribution channels. In choosing which markets to serve, an organization will de facto determine the industry in which
it competes. For example, white goods such as refrigerators and washing machines are distributed through the same
channels, yet only refrigerators chill food and washing machines clean clothes. The markets, based on consumer demand,
are for chilled food storage and laundry services. Therefore, we can see that although a domestic appliance industry exists
based on a common technology (white boxes with motors in them), a domestic appliance market does not.3
Business strategy is a means of separating out and formulating a competitive strategy at the level of the individual
business unit. This is sometimes referred to as a strategic business unit (SBU). A strategic business unit is a distinct
part of an organization which focuses upon a particular market or markets for its products and services. It should be
remembered that a parent company sets the overall or corporate strategy. The role of the business unit is to devise
a strategy that allows it to compete successfully in the marketplace and to contribute to the corporate strategy. In
this respect, the managers of a business unit may have considerable autonomy to devise their business strategy. This
reflects their knowledge of local markets, customers, and competitors. However, this cannot be decided in isolation
from the corporate strategy being pursued. The business unit managers must ultimately show that their business
strategy contributes to the corporate strategy.
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Corporate strategy focuses upon the fundamental question ‘What business (or businesses) do we want to be in?’, and
is discussed in Chapter 7. If corporate strategy answers the question ‘What business should we be in?’, or more accurately ‘Which markets do we want to serve?’, it remains for competitive or business strategy to answer the question
‘How are we going to compete in our chosen markets?’4 The key to bear in mind with business strategy is that it is
always in pursuit of a sustainable competitive advantage. The question is how it achieves this. To answer this, we will
start by evaluating Porter’s generic competitive strategies.
A competitive advantage is about performing different activities or performing similar activities in different ways.
In other words, the firm must be capable of producing value for the consumer that is recognized as being superior
to that of its competitors. It is precisely because competitive advantage is determined vis-à-vis your competitors
that Porter’s analysis is concerned with the competitive environment of industry structure and the five competitive forces. Porter argues that competitive strategy is about developing a defendable position in an industry that
enables you to deal effectively with the five competitive forces and, thus, generate a superior return on investment
for the firm.5 To achieve superior value that is recognized by the consumer the firm can do one of two things. First,
it can offer its products or services at a lower price than rivals, but without sacrificing the quality of the product.
Second, it can produce a differentiated product that consumers perceive to be of better value than the product
offerings of rival firms, and hence charge a premium price for its goods. In addition, the firm must choose which
market segments it wants its products to compete within. That is, does it want to try to cover all or most market
segments and adopt a broad based approach? Or, would it be content to compete within a particular market niche
which may require a different set of resources and capabilities, and which may be overlooked by rivals seeking to
gain dominant market shares?
Whilst recognizing that the best strategy for an organization will actually be unique and reflect its individual circumstances, Porter developed three generic strategies to help an organization outperform rivals within an industry, and so
successfully position itself against the five forces we discussed in Chapter 3. These business strategies are referred to
as generic because they apply to different types of organizations in different industries. They are overall cost leadership,
differentiation, and focus strategies.
1. Overall cost leadership
A cost-leadership strategy involves a firm being the lowest-cost producer within the industry while maintaining the industry standard. This allows the firm to outperform rivals within the industry because it can charge
lower prices and its lowest-cost base still allows it to earn a profit. In effect, this firm can charge the lowest price
within the industry, which rivals simply cannot match. Therefore, a cost-leadership strategy allows the firm to
make superior profits. Ryanair, is the overall cost leader in the airline industry, with its no-frills service and highly
focused cost reductions, which allow it to charge lower prices while generating substantial profits.
2. Differentiation strategy
A differentiation strategy is based on an organization producing products or services which are perceived
by customers as unique or superior to competitor offerings. It presents an opportunity to create greater value
by meeting customer needs more closely than rivals. It is this perceived added value that is the basis on which
customers are prepared to pay a premium price. Clearly, the cost of producing the differentiation must not
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6.2 Generic Competitive Strategies
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High-end fashion stores, such as Burberry, adopt a focus strategy . Source: © Arsenie Krasnevsky/Shutterstock.com
6
outweigh the price being charged. Or, put another way, customers should be prepared to pay a price which
exceeds the cost of the differentiation, thereby allowing the organization to earn superior profits. Apple follows a differentiation strategy with its innovative product design for which consumers are prepared to pay a
premium price.
3. Focus strategy
A focus business strategy allows an organization to target a segment or niche within the market. The segment
may be based on a particular customer group, geographical market, or specific product line. Unlike overall costleadership and differentiation strategies, which are industry-wide, a focus strategy is aimed at serving a particular
target market efficiently. A focus strategy is adopted by companies selling high-end jewellery and fashion brands,
for example, Burberry. These generic strategies are shown in Figure 6.1.
Figure 6.1 illustrates Porter’s generic strategies and shows how an organization can choose to adopt a broad based
approach that seeks to cover most (or all) markets within the industry, that is, engage in a broad target. Alternatively, the firm may choose to focus upon a narrow strategic target (segment) of the industry. Whichever strategic
Three Generic Strategies
Competitive Scope
Competitive Advantage
Industrywide
Particular
Segment Only
Differentiation
Low Cost
Differentiation
Overal
Cost Leadership
Focus
Figure 6.1 Three generic strategies. Source: Reprinted with permission of The Free Press, a Division of Simon & Schuster Inc., from Competitive Strategy:
Techniques for Analyzing Industries and Competitors, by Michael E. Porter. Copyright © 1980, 1998 by The Free Press. All rights reserved.
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target—broad based or narrow segment—the organization chooses to concentrate its resources and capabilities on,
it must then adopt either a cost-leadership strategy or a differentiation strategy. As we shall see later, Porter warns
organizations about the dangers of attempting to pursue these three strategies simultaneously.
6.2.1 Overall Cost-Leadership Strategies
●
aggressive construction of efficient-scale facilities
●
vigorous pursuit of cost reductions from experience
●
tight cost and overhead control
●
avoidance of marginal customer accounts
●
cost minimization in areas like research and development (R&D), service, sales force, and advertising.
In reality, the organization must concentrate on all the activities that occur within its value chain and ensure
that the costs associated with each activity are sufficiently pared down. At the same time, it must also ensure
that all these activities are also properly coordinated across its value chain. Value chain analysis was discussed in
Chapter 4.7
An overall cost-leadership strategy implies a high market share and standardized products that utilize common
components. This allows the organization to achieve economies of scale and reduce costs. Therefore, the organization may have to invest in the latest technology to reduce manufacturing costs and production processes. Such a
decision will only be undertaken if it allows the organization to achieve its lower-cost strategy. A low cost position
within the industry can create a virtuous circle in which the higher margins achieved by the low cost company allow
it to continually reinvest and update plant and equipment, which in turn further reduces costs, which increases
margins, and so on.
For some time now car manufacturers have ensured that new models, which are expensive to develop, share common platforms with existing cars, thereby reducing their manufacturing cost. Toyota has achieved a low cost position
within the automobile industry and earns more revenue in a year than the three largest US auto producers, General
Motors, Ford, and Fiat Chrysler, combined. When average earnings per vehicle are calculated, the Japanese automaker
makes more than four times per car than General Motors.8 Toyota continues to perpetuate this position by utilizing
lean manufacturing processes within and across its value chain. In Toyota’s case this low cost production has achieved
above-average quality standards. Notice also that any differentiation that does occur within the industry is matched by,
or more accurately driven by, Toyota.
The Experience Curve
The concept of the experience curve was developed by the Boston Consulting Group in 1968 and helps an
organization identify a relationship between its costs of production and its accumulated experience. The
6
We should note that implementing each of the three generic strategies will involve organizations in utilizing different
resources and capabilities. For example, the capabilities required to be a low cost producer will often differ markedly
from the capabilities required to produce a differentiated product. A cost-leadership strategy is adopted when an
organization seeks to achieve the lowest costs within an industry and targets its products or services at a broad market.
A cost-leadership strategy requires an organization to pursue:6
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Direct costs per unit
C
EC
Cumulative volume of production
X
Figure 6.2 The experience curve.
6
experience curve suggests that as output doubles the unit cost of production falls by between twenty and thirty
per cent. The actual percentage reduction in costs will vary between different industries. However, as a general
rule, we can say that if a product costs £10 per unit to produce, for example, and a firm produces 100 units, if the
organization doubles its output to 200 units, the cost will fall to between £7 and £8 per unit. The experience
curve is shown in Figure 6.2.
If we apply this concept to the overall cost leader, we can see that a result of its dominant market share is that it will have
accumulated the greatest experience, and it is this experience (or learning) which allows it to reduce its costs. And as we
saw in Chapter 5, the ability to learn is recognized as a dynamic capability. As its market share continues to grow so its
costs differential with rivals within the industry widens as it moves further down the experience curve. The corollary of
this is that an organization should pursue a strategy of growth which enhances its accumulative experience and further
lowers its costs. The experience curve allows an organization to anticipate cost reductions based upon future growth in
sales because each doubling of sales reduces cost by between twenty and thirty per cent. The idea then is to price its current products on this anticipated cost reduction. The effect is to undercut competitors, increase market share, and thereby
benefit from cost reductions, which increase profit margins. In theory, cost savings due to accumulated experience can
continue ad infinitum although, in reality, you might expect the rate of reduction to decrease over time. Where cumulative experience is less important within an industry, one would expect other factors to outweigh the experience curve.
Economies and Diseconomies of Scale
Another source of cost advantage for the firm derives from economies of scale. This occurs as a firm increases its volume
of production so its average cost of production falls. In effect, we’re looking at how an increase in production affects
the long-run average total cost (LRATC) curve of the firm.9 Economies of scale tend to be associated with industries that
have high fixed costs, such as aircraft manufacture and breweries. This is shown as a falling ‘U-shaped’ curve in Figure
6.3. Given the huge research and development costs involved in aircraft production, it is necessary that sufficient
aircraft be sold to commercial buyers to offset these costs.
Although these high fixed costs act as a barrier to entry for other firms, it also ensures intense rivalry between aircraft
manufacturers, Boeing and Airbus. Economies of scale derive from larger firms being able to purchase big, specialized
CHAPTER 6 Business Strategy
Economies of
scale
Average
Cost
149
Diseconomies
of scale
LRATC
Constant
returns to scale
Low
Q1
Q2
Q1
Volume of Production
Figure 6.3 Economies of scale.
Although economies of scale provide a cost advantage to large firms with high fixed costs, there does comes a point
when average total costs will start to rise. At this point, the firm begins to experience diseconomies of scale. Diseconomies of scale can occur when an organization gets so large that management is unable to cope efficiently with
the complexity and coordination of its operations. Furthermore, with the increased specialization of roles necessary for
mass production can come a degree of worker alienation and de-motivation. This may result in less efficient production and potential quality issues. Diseconomies of scale occur when an increase in a firm’s output causes a more than
proportionate increase in its cost and is shown as Q2 in Figure 6.3. As diseconomies of scale begin to set in, the LRATC
curve starts to rise.
Between economies and diseconomies of scale lie constant returns to scale. This is where an increase in a firm’s output
causes a proportionate increase in its cost. The firm can expand its production without affecting its LRATC curve; this
is shown in Figure 6.3.
Advantages of Cost-Leadership Strategies
A major benefit of being the lowest-cost competitor within an industry is that it allows an organization to generate
above-average profitability even where intense competition exists. For example, Ryanair’s lower cost base allows it to
still earn a return after the other (higher-cost) competitors have competed away their profit through rivalry. Similarly,
its low cost position allows the company to defend itself against buyers who can only drive prices down to the level
of the next most efficient competitor. Even in this unlikely situation, the overall cost leader can still generate positive
returns. When faced with the bargaining power of suppliers, being a low cost producer provides a hedge against any
increases in their input prices, such as fuel. Should there be a threat of entry from firms outside the industry, Ryanair is in
an advantageous position to compete on price which effectively acts as a barrier to entry. Finally, as the low-price competitor Ryanair will be in a better position than its competitors to counter substitutes such as the ferry and Eurotunnel,
given its superior price–performance ratio. Porter argues, ‘fundamentally, the risks in pursuing the generic strategies
6
capital equipment that a smaller firm would simply not be able to afford. This expensive equipment requires large
production runs in order to efficient. Smaller firms are simply unable to achieve the volume of production necessary to
offset the cost of purchasing such equipment.
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are two: first, failing to attain or sustain the strategy; second, for the value of the strategic advantage provided by the
strategy to erode within industry evolution’.10
The risks of following an overall Cost-Leadership Strategy
A low cost position protects the organization against all of the five forces. However, there are risks associated with this
strategy.
●
A cost-leadership strategy can prove expensive, as the organization continually updates its capital equipment.
●
There is also the ease with which competitors may be able to imitate the activities of the cost leader.
●
A change in technology may invalidate the cost leader’s past investments in capital equipment and allow competitors to take market share.
●
Customer tastes may change, which results in them being less price sensitive and more willing to pay a higher
price for a differentiated product. An organization following an overall cost-leadership strategy may not be able
to readily adjust to these market changes.
6
6.2.2 Differentiation Strategies
A differentiation strategy is aimed at a broad market and involves the organization competing on the basis of a product
or service that is recognized by consumers as unique. This difference must be sufficiently valued by consumers that
they are willing to pay a premium price for it. A major benefit of producing a differentiated product is that rivals will
find it difficult to imitate. We might add that the choice of a differentiation strategy by an organization will involve different resources, capabilities, and organizational arrangements from a strategy based on cost leadership. It is for this
reason that Porter believes an organization which seeks to follow more than one of the generic strategies is confused,
or is what he refers to as ‘stuck in the middle’.11
Organizations may differentiate their product offerings in a variety of ways. These include:
●
product design or brand image (e.g. BMW, Apple, Dyson)
●
customizing products to suit consumers’ specific requirements (e.g. Apple)
●
state-of-the-art technology (e.g. Dyson, Intel, Amazon)
●
marketing abilities (e.g. Procter & Gamble, Amazon, Apple)
●
reliability (e.g. Toyota, BMW)
●
customer service (e.g. John Lewis, Amazon).
In reality, we would expect the organization to use a number of dimensions on which it can differentiate its product.
Hence companies will occupy more than one dimension. When evaluating its value chain, the organization would then
be able to point to different activities where it is clearly differentiated from its competitors. Although the aim of a differentiation strategy is not to focus primarily on costs, it is clearly important that the organization has some knowledge
of its cost structure. Then any differentiation achieved can be set at a price which customers will be prepared to pay and
that easily covers the cost of the differentiation.
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Advantages of Differentiation Strategy
A differentiation strategy allows an organization to achieve above-average profits in an industry by creating a defensible position for coping with the five forces. For instance, differentiation provides a defence against competitive rivalry
because it creates brand loyalty that helps protect the organization from price competition. This brand loyalty and
unique product offering have to be overcome by entrants thinking of entering the market, which acts as a barrier to
entry. The power of buyers is constrained as they lack a comparable alternative. A differentiation strategy provides the
organization with higher margins that enables it to deal more easily with cost pressures from suppliers. In addition,
suppliers may value the benefits that derive from being associated with a successful product or service. Finally, a successfully differentiated product has customer loyalty that protects the organization from the use of substitutes. The
more difficult it is for competitors to imitate the differentiation, the more likely it will be for the organization to achieve
a sustainable competitive advantage. This implies that the basis of the differentiation is not readily identifiable, and
even when known, is far from easy to replicate.
Risks of following a Differentiation Strategy
●
The organization must ensure that the high price charged for differentiation is not so far above competitors that
consumers perceive the difference as not worth paying, and it results in reduced brand loyalty.
●
Buyers may decide that their need for a differentiated product has declined. For example, the use of the Internet
has greatly reduced the search costs involved in comparing products.
●
Competitors may narrow the attributes of differentiation that results in consumers being faced with a viable
substitute.
6.2.3 Focus Strategies
Whereas the low cost and differentiation strategies we have discussed are aimed at the entire industry, a focus
strategy is aimed at serving one or only a few segments of the market. This might be a particular group of consumers
or a specific geographical market—in effect, any viable segment of the market. For example, the German automotive manufacturer Mercedes-Benz, continues to provide the comfort, performance, and safety consumers have come
to expect from the brand, while also offering dramatic styling and innovative new features. Porter argues that by
focusing on a narrow segment or niche of the market, the organization may be better placed to meet the needs of
buyers than competitors who are trying to compete across the whole industry. By focusing on the needs of particular
segments that exist within the industry, an organization can achieve competitive advantage either through lower
costs or differentiation. For example, the Jaguar F-Pace is Jaguar Land Rover’s offering to compete in the luxury sport
utility vehicle (SUV) segment of the automotive industry.
Cost-Focus Strategy
With a cost-focus strategy, the firm seeks to become the cost leader, but only within a particular segment of the market.
Similarly, with a differentiation-focus strategy, the firm seeks to differentiate its products or services to effectively meet
the needs of a particular segment of the market. A focus strategy is predicated upon the firm being able to exploit only
some of the differences within the industry. The firm may target segments that it believes it can more readily defend
6
As with an overall cost-leadership strategy, a differentiation strategy has inherent risks.
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6
Since the financial crisis budget supermarkets like Aldi have seen success with a cost-focus strategy . Source: © Joe Seer/Shutterstock.com
from competition. A cost-focus strategy may be possible because larger competitors within the industry have cost
advantages that derive from economies of scale, but may be unable to produce cost-effective small production runs.
The same logic applies to custom-built orders that do not allow larger competitors to exploit their economies of scale
based upon standardization.
For example, the German retailer Aldi continues to thrive in the discount segment of retailing. A typical Aldi
store is relatively small (around 15,000 square feet) and has about 700 products, ninety-five per cent of which are
store brands. This compares with the 25,000 plus products that a more traditional supermarket carries. As with a
cost-leadership strategy, quality cannot be sacrificed for cost savings. For instance, in taste tests many of Aldi’s
own-label products have beaten branded products. Aldi stores its products on pallets rather than shelves to cut
the time it takes to restock and therefore to cut costs. It is difficult to see traditional supermarket retailers wanting
to imitate this practice or, indeed, having the capability to manage costs in this niche market. Since the financial
crisis, many consumers have flocked to Aldi’s lower prices and unbranded goods, allowing both Aldi and Lidl to
take market share from the big players in the supermarket industry. This would imply that the market for Aldi and
Lidl’s products has changed providing them with an opportunity to compete across the supermarket industry.
Differentiation-Focus Strategy
A differentiation-focus strategy offers a unique product that is highly valued within a segment of the market. The
special needs within that segment are perceived to be more effectively met by the niche player than by rivals who compete across the market (see Strategy in Focus 6.1). This in turn helps to develop brand loyalty which makes entry by
other competitors more difficult. As with broad based cost leadership and differentiation, the extent to which a focus
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strategy achieves a sustainable competitive advantage will depend upon the organization’s resources and distinctive
capabilities and the ease with which these can be imitated. In addition, the durability of the segment may be an issue,
as it may be less durable than the industry as a whole.
STRATEGY IN FOCUS 6.1 Differentiated Product Jaguar
6
F-Pace SUV
The F-Pace is the first SUV by Jaguar; it is a performance SUV that combines maximum driving exhilaration with efficiency . Source: © Yauhen_D/
Shutterstock.com
Jaguar’s New F-Pace
When it comes to car design, there is also much to recommend a slow start. Sit back, let the competition take
the gamble, and put in the hard yards in R&D. Then, when the market is mature, the demand created, the errors
thrashed out, you pounce. BMW, Porsche, and Audi all blasted on to the luxury SUV circuit more than a decade
ago, and even they were a generation behind Range Rover and Land Rover. Now, making its very late entry to
the party is Jaguar’s first ever SUV—the F-Pace. It has already picked up twenty-five global awards and is the
fastest-selling Jaguar ever, with more than 50,000 already sold since its launch.
Customers can’t get enough of the luxury crossover. Part limo, part off-road bruiser, part highway cruiser,
they give you a bit of everything you fancy. And the F-Pace does it all very neatly: it’s big, but not colossal; fast,
but not terrifying; luxurious, but not ostentations; capable, but probably not one for heading to Antarctica in.
Being part of the Jaguar Land Rover group, you’d think creating an F-Pace to go head-to-head with stable
mates such as the Evoque and Discovery Sport would be foolhardy to say the least. But Jaguar has made it clear
from the outset that the F-Pace is all about performance.
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Inside there are plenty of luxurious touches and it’s packed with technology, from head-up display to surround
camera and auto parking function. You can download an app that lets you remotely preheat or precool the car
and check its vital statistics. It also has an ‘Activity Key’—a sort of waterproof bracelet fob. Jaguar imagines
many of its new customers will not be old men in golfing slacks vying for the most conspicuous parking spot at
the golf club, but fit young people heading to the coast for some kite surfing and a beach barbecue.
Source: Martin Love, ‘Second to none, Jaguar F-Pace’, The Guardian, 12 March 2017. Reproduced with permission.
Advantages of Focus Strategies
The same factors that apply to overall cost-leader and differentiation strategies discussed above also apply to a focus
strategy. As with low cost and differentiation strategies, a focus strategy can provide a defence against competitive
forces.
The Risks of following a Focus Strategy
6
The risks of a focus strategy are:
●
That the segment may not be durable; for instance customer preferences may change and the niche player may
be unable to respond
●
broad-based competitors believe the segment represents an attractive submarket and out-focuses the focuser
●
The difference between the segment and the main market narrows, leaving focus-based competitors at a
disadvantage.
6.2.4 Stuck in the Middle
Michael Porter’s generic strategies represent different approaches for dealing with competitive forces within an industry. In contrast, an organization that tries to pursue more than one of these generic strategies is referred to as stuck in
the middle. A firm stuck in the middle lacks the market share and capital investment to be a low cost producer. It does
not possess the industrywide differentiation which would preclude the need to be a low cost producer. Nor does it
have the focus capabilities to create differentiation or a low cost position in a few segments.12
It is, therefore, unwise for an organization to try to pursue both a low cost strategy and a differentiation strategy. Whilst
the actual choice of generic strategy will be dictated by the organization’s resources and capabilities, it should seek
to make a definitive choice as each generic strategy is mutually inconsistent. However, the empirical evidence is less
clear cut.
Criticisms of Generic Strategies
While many firms may choose to adopt a low cost strategy or differentiation strategy, it may not be true to suggest
that these are inconsistent. Organizations are increasingly finding that a route to competitive advantage is being able
to combine being a low-cost producer with some form of differentiation; this is referred to as a hybrid strategy. Such
a strategy is adopted by the Swedish furniture manufacturer IKEA, which provides low cost manufacture with a differentiated product. Often the two are complementary, so that being a cost leader allows an organization to invest in
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differentiation required by the market. Eva Pertusa-Ortega and colleagues undertook a sample of 164 Spanish firms in
different sectors and found a large number of organizations use hybrid strategies.13 They also found that such strategies tend to be associated with higher levels of organizational performance than a firm simply pursuing one generic
strategy, such as cost leadership.
In the UK supermarket retailers selling similar foodstuffs have sought to differentiate themselves through selling clothing, consumer electronics, savings products, and garden furniture, in the process turning themselves into department
stores selling food! For example, Tesco, the market leader, continues to expand its range of non-food items as it moves
into higher-margin goods and services. The problem for all supermarkets is that such products are easily imitated by
rivals. There is some, albeit ambiguous, evidence that organizations trying to pursue more than one generic strategy
may end up stuck in the middle. For example, Sainsbury’s was stuck in the middle trying to sell higher-priced foods, but
with the slogan ‘Good food costs less at Sainsbury’s’. Its foodstuffs were not perceived by consumers to be sufficiently
differentiated to warrant a premium price when compared with other supermarkets. Nor were its operations sufficiently low cost to be able to compete on price. In trying to be simultaneously a low cost producer and a differentiator,
it conceded market leadership to Tesco.
In the same way, the British retailer Marks & Spencer found that its clothes were no longer perceived by consumers
to be differentiated on the basis of outstanding value for money. Instead, the retailer saw its fortunes decline as it
grappled with tired clothing lines, loss of identity, incoherent objectives, and no clear vision. It was unable to compete
effectively with competitor retailers such as Next. Moreover, it struggles to compete effectively with the logistics of a
fast fashion outfit such as Zara, which is able to rapidly change its store inventory based on real-time consumer purchasers. M & S, which historically prided themselves on their quality British-made goods, were forced to source their
supplies from low cost economies. Its famous customer service and no-quibble money-back guarantee was no match
for poor product lines.
6.3 A Resource-Based Approach to Strategy
Formulation
The resource-based view of strategy (discussed in Chapter 5) argues there are two fundamental reasons for making
the resources and capabilities of the firm the foundation for its strategy. First, internal resources and capabilities
provide the basic direction for a firm’s strategy and, second, resources and capabilities are the primary source of
profit for the firm. Robert Grant distinguishes between resources and capabilities.14 He sees resources as inputs
into the production process. A capability is the capacity for a team of resources to perform some task or activity.
Therefore, resources are the source of an organization’s capability. And it is capabilities that are the main source of
its competitive advantage.
6
Consider, for example, the Japanese auto manufacturer Toyota. It has an enviable record on cost reductions while
at the same time its cars are differentiated from other major players such as Ford and General Motors. Therefore, it
occupies a position in which it is the overall cost leader in the auto industry, but its products are also renowned for reliability providing them with differentiation and brand loyalty. Far from being ‘stuck in the middle’ Toyota’s approach of
differentiation and low cost manufacturing has proved to be the most profitable strategy.
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In a constantly changing world Grant argues that a focus solely upon the external environment may not provide a
sufficient foundation for a long-term strategy. This is because when the external environment is constantly changing,
‘the firm’s own resources and capabilities may be a much more stable basis on which to define its identity. Hence, a
definition of a business in terms of what it is capable of doing may offer a more durable basis for strategy.’15
6
A focus on which markets the organization competes in and, therefore, which customer needs it seeks to satisfy may
be inappropriate when faced with a rapidly changing environment. Given this type of environment, the focus instead
should be on internal factors. The resource-based view argues that even the choices articulated by Porter, competing
on cost or differentiation within a broad or narrow market, are themselves predicated upon the capabilities within
the organization. Since no organization can hope to follow an overall cost-leadership strategy if it does not possess
economies of scale and technically proficient plant and machinery.
The aim of the resource-based approach to strategy formulation is to maximize Ricardian rents. Ricardian rents
are the surplus that is left over when the inputs to a productive process, which includes the cost of capital being
employed, have been covered. As resources depreciate or are imitated by competitors, so the rents they generate
also begin to diminish. To appreciate rents fully we need to understand the relationship between resources and
capabilities. While resources that reside within an organization may be largely transparent and, therefore, easy to
identify, an organization may be less capable of assessing its capabilities objectively. This is because some features of
an organization’s capabilities will be unique and not easily captured as part of its value chain analysis. What is essential is that an organization can assess its capabilities in terms of those that its competitors possess, thereby allowing
it to exploit any differential advantage.
Organizational capabilities require that the knowledge of individuals is integrated with an organization’s resources
such as its capital equipment and technology. This is accomplished by what Nelson and Winter refer to as organizational routines.16 We saw in Chapter 5 that organizational routines are regular, predictable, and sequential patterns
of work activity undertaken by members of an organization. Therefore, an organization’s capabilities comprise a
number of interacting routines. For resources and capabilities to operate efficiently the organization must achieve
cooperation and coordination between routines. Therefore, the type of management style within the organization,
its vision, and its values are all crucial ingredients to achieve the efficient operation of routines. An organization’s
capability is path dependent; it is the result of everything that has happened to it since its inception. The danger with
this is that an organization’s core capability can easily become a core rigidity, stifling the need to change when its
environment changes.17
6.3.1 Appraising Capabilities
The profits that accrue to a firm’s capabilities depend upon three factors: (1) establishing a competitive advantage;
(2) sustaining a competitive advantage which the capabilities confer; and (3) the ability of the firm to appropriate the
profits (or rents) earned from its capabilities.18
1. Establishing a competitive advantage
In order for a capability to establish a competitive advantage it must be scarce; that is, not widely available within
the industry. When an organization possesses capabilities which few other organizations possess, such as Toyota’s
capability in manufacturing, it provides a source of competitive advantage. In addition, a capability must also be
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relevant. Relevance implies that the capability meets the key or critical success factors for superior performance
in an industry, those factors in an industry which keep customers loyal and allow the organization to compete
successfully.
Durability refers to the rate at which an organization’s resources and capabilities depreciate or become
obsolete. While resources such as capital equipment may be quickly depreciated by technological changes, other
resources such as an organization’s brand tend to depreciate far slower. In contrast, an organization’s capabilities
may experience greater longevity. This is because the organization may be able to replace the resources on which
the capabilities are based more readily as they wear out. Interestingly, corporate culture plays a part in sustaining
competitive advantage by ensuring the continuity of capabilities through its socialization of employees.19
Transferability refers to how easily a competitor can buy the resources and capabilities necessary to duplicate
a competing organization’s strategy. If an organization can acquire resources and capabilities on similar terms
to their rival, then its competitive advantage will be unsustainable. However, we might expect that an organization that is first to acquire such resources and capabilities may acquire some advantage through its experience
and knowledge of these resources which competitors will lack (first-mover advantages).20 Similarly, capabilities
may be less transferable as they represent a collection of interactive resources. It may be that the only way to
imitate the competitive advantage of a rival is to transfer capabilities in their entirety, for example, the capability contained within a team of fund managers. However, the dynamics present in one organization that allow a
capability to flourish may not be present to the same extent in another organization.
Replicability is the use of a firm’s internal investment to build the resources or capabilities of competitors.
Where the capabilities are based upon complex organizational routines, this will be far more difficult. Even where
an organization’s routines seem relatively straightforward they may be difficult for competitors to imitate successfully. Although Ryanair’s business model is fairly transparent, no other competing airline is able to match its
level of profitability.
3. Appropriating the profits earned from capabilities
The extent of the profits deriving from a firm’s capabilities will depend not only on its ability to sustain its
­competitive advantage, but also on its ability to appropriate or capture these profits for itself. This will depend
upon the balance of power between the firm and its employees. Where an employee’s contribution to the firm is
readily identifiable, and their skills are scarce and easy to take from firm to firm, we would expect the employee
to be in a strong bargaining position for a share of the profits. However, where the employee’s contribution is not
so clearly defined and is enhanced by the organizational routines within the firm, we might expect the firm to
appropriate greater returns.
6.3.2 Implications for Strategy Formulation
We have seen that an organization’s most valuable capabilities are those that are durable, imperfectly transferable,
difficult to replicate, and in which it has clear ownership. Given this, its strategy should be based upon exploiting these
capabilities, which limit its activities to where it possesses a competitive advantage. For example, the British car manufacturer Morgan builds handmade sports cars for a specific segment of the market, playing to its strengths rather than
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2. Sustaining a competitive advantage
The characteristics of capabilities that provide for the sustainability of a competitive advantage are: durability,
transferability, and replicability.
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4. Select a strategy which best
exploits the firm’s resources
and capabilities relative to
external opportunities.
Strategy
3. Appraise the rent-generating
potential of resources and
capabilities in terms of:
(a) their potential for
sustainable competitive
advantage; and
(b) the appropriability of
their returns.
Competitive
Advantage
2. Identify the firm‘s capabilities:
what can the firm do more effectively
than its rivals? Identify the resources
inputs to each capability, and the
complexity of each capability.
6
1. Identify and classify the firm’s
resources. Appraise strengths and
weaknesses relative to competitors.
Identify opportunities for better
utilization of resources.
5. Identify resource gaps
which need to be filled.
Invest in replenishing,
augmenting, and upgrading
the firm’s resource base.
Capabilities
Resources
Figure 6.4 Strategy formulation: a resource-based approach. Source: Adapted from R. M. Grant and J. Jordan, Foundations of Strategy, Wiley (2015) p. 111
trying to compete on price against mass-market players such as Ford. The dynamic of the marketplace necessitates
that competitors constantly focus upon updating their competitive advantages rather than trying vainly to shore up
their existing advantages, which will simply be imitated.
Figure 6.4 provides a four-stage model to guide organizations in their strategy formulation. The start point is to
identify the resources and capabilities that already exist inside the firm. Stage 2 requires the firm to understand the
relationship between its resource inputs and how these provide it with a capability. This is a difficult challenge for
managers since, as we saw in Chapter 5, this relationship is not always clear. Stage 3 involves an appraisal of the firm’s
resources and capabilities. Some of these resources and capabilities will be necessary simply to compete in the market,
while others provide a source of competitive advantage.
The firm needs to identify which capabilities provide it with competitive advantage and are of strategic importance.
The firm also needs to know which of its capabilities are a strength; that is, what activities it can perform better than
its competitors. In stage 4, the firm uses the preceding analysis to formulate a strategy which allows it to exploit its
strengths in relation to the opportunities that exist in the market. At the same time, the strategy should allow any
competitive weakness in the firm’s activities to be outsourced or acquire new resources and capabilities to try to turn
these weaknesses into a strength.
The overall objective is to analyse a firm’s resources and capabilities as a potential route to sustainable competitive
advantage. This analysis then forms the basis of strategy formulation.
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To ensure sustainable competitive advantage, an organization needs to upgrade its resources and capabilities based
on what it believes will be the basis of future competition. To do this, the organization needs to be able to appraise its
competitive environment and to evaluate trends which may start within the macro-environment, but which have their
greatest impact in the competitive environment. These trends will determine the capabilities required to compete successfully in the future. Prahalad and Hamel refer to these capabilities as core competencies.21
One approach to assess the external environment is to try to identify the weak signals we discussed in Chapter 2.
Another is to produce a series of scenarios (also discussed in Chapter 2) based on what the organization believes may
occur in the future. The goal is for an organization’s strategy to go a little beyond its current resources and capabilities
to ensure that the resources and capabilities necessary to address future competitive challenges are being built up.22
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Porter’s generic approach to business strategy is often characterized as static and incapable of dealing with a
dynamic competitive landscape.23 Others point to the use of hybrid strategies in which an organization might
simultaneously pursue both a cost-leadership strategy and a differentiation strategy.24 There is empirical support
for and against Porter’s generic strategies.25 Kay tends to dismiss the concept of generic strategies, arguing instead
that each organization is sufficiently different to make such generalizations of limited value.26 He argues that,
because the distinctive capabilities of organizations differ, any search for generic strategies will inevitably fail. This
is because their general adoption by organizations would simply negate any competitive advantage that might
have been derived. He reasons, ‘there can be no such recipes because their value would be destroyed by the very
fact of their identification’.27
To summarize, the resource-based view shifts the discussion on competitive advantage from an emphasis on the
competitive environment to the resources and capabilities inside the organization. The focus of attention becomes the
configuration of resources to create capabilities. Moreover, as we saw in Chapter 5, a firm needs dynamic capabilities
in order to compete in rapidly changing markets. A criticism made of the resource-based view is that it is unclear how
resources and capabilities evolve over time.28 However, the purpose of strategy remains the same in each perspective; for the organization to exploit the opportunities within its business environment by playing to its strengths and
transforming its weaknesses. It is how the organization gets to this position that generates contention. There is empirical support for both views, suggesting perhaps that they should not be seen so much as incompatible, but more as
occupying different positions on the same continuum.29
6.4 Blue Ocean Strategy
W. Chan Kim and Renee Mauborgne suggest that companies need to create and capture blue oceans of uncontested
market space.30 They envisage the business world in terms of red oceans and blue oceans. Red oceans represent all the
industries that currently exist today; the known market space. In contrast, blue oceans represent all the industries not
in existence today; the unknown market space. In red oceans, industry boundaries are clearly defined and accepted by
competitors in the industry. The objective is to outperform your rivals and gain a greater share of existing demand. As
more firms compete for this finite demand, so profits and growth rates reduce. In contrast, a blue ocean represents a
strategic position unoccupied by competitors that has the potential for demand creation and highly profitable growth.
Although a blue ocean can be created outside the existing industry boundaries, for example, eBay for on-line auctions,
most blue oceans are created within red oceans by expanding existing industry boundaries.
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6
Performers skipping rope at Cirque du Soleil’s show ‘Quidam’. Source: © Ververidis Vasilis/Shutterstock.com
To create blue oceans and sustained high performance requires an analysis of the strategic move rather than an analysis of the company or the industry. A strategic move is defined as ‘the set of managerial actions and decisions involved
in making a major market-creating business offering’.31 Their research suggests that companies which create blue
oceans focus on value innovation.
Value innovation occurs when organizations shift their focus from beating the competition to making the competition
irrelevant by placing equal emphasis on both value and innovation. Value innovation goes against Porter’s assertion
that an organization can pursue either differentiation or a low cost strategy. It implies that companies which seek to
create and capture blue oceans can pursue differentiation and low cost at the same time. A key feature of value innovation is that market boundaries and industry structure are not given, but they can be reconstructed by the actions and
beliefs of industry players.32
An example is Cirque du Soleil, which created a new product offering by expanding existing industry boundaries to go
beyond the traditional circus. Instead it substantially upgraded the tired format of tent venues and blended circus with
theatre, dance, and music. In the process, it created an entirely new group of consumers prepared to pay a premium for
unique entertainment. At the same time, it eliminated the high-cost elements of the circus such as star performers and
the use of animals, thereby reducing its cost structure. It introduced a high level of comfort for the audience instead of
traditional hard benches. The performance was more akin to a theatre and ballet production and showcased original
scores and assorted music. By not trying to compete with the existing circus format, Cirque du Soleil made traditional
circus offerings irrelevant to it and created uncontested market space. Amazon has done the same thing for bookselling
(see Strategy in Focus 6.2). It shifts the retailing of books from bricks-and-mortar buildings to the virtual offices of the
Internet. This has made traditional book sellers of lesser concern to Amazon. Amazon is also seeking to create a blue
ocean in the delivery of products by aerial drones. Both Cirque du Soleil and Amazon are value innovators.
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STRATEGY IN FOCUS 6.2 Amazon’s Blue Ocean Strategy
Could delivery drones be a common sight in the future? Source: © Sanit Fuangnakhon/Shutterstock.com
The internet retail giant has secured an agreement with UK authorities to develop the technology to deliver
products by drone within thirty minutes of receiving an order via its Prime Air service. Amazon is taking
advantage of the UK’s willingness to embrace a burgeoning interest in the unmanned aerial vehicle sector. The
UK, which wants to establish itself as a world leader in unmanned vehicles of all types, has extended that cooperation, with the Civil Aviation Authority relaxing normal rules requiring drones to stay within ‘line of sight’ of
their operators—taken to be about 1,500 ft—and not to fly above 400 ft to avoid other air traffic.
However, Amazon is determined to make Prime Air a reality, with chief executive Jeff Bezos personally
supporting the programme. But putting aside technological challenges, is there really a market for deliveries
by drone? Amazon says almost ninety per cent of its current orders weigh below 2.25 kg, meaning they will be
able to be delivered by drone. Human nature is also set to drive demand for drone delivery services, especially
as Amazon does not see a major extra cost once the technology is perfected, and analysts think it could add just
$1 (77p) to an order.
‘One should never underestimate the seductive power of instant gratification’, says an independent retail
analyst. ‘Delivery by drone will allow Amazon to add value in the way that going into a shop and being helped
by assistants adds value. It’s allowing Amazon to not just level the playing field, but to create one of its own and
disconnect itself from rivals who will be unable to keep up.’
Some critics argue that customers will never feel they so urgently need to have, say, a certain book, within
thirty minutes to justify a drone service, but Amazon sees airborne delivery as being economic enough that
everyday sundries will be arriving by drone. Paul Misener, Amazon’s vice president of global innovation policy
and communications, says: ‘If a customer runs out of coffee or toothpaste, two-day shipping may not be the
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right choice. We’re developing shipping options so they can choose what works best for them.’ The company
imagines scenarios such as having forgotten to bring a corkscrew to a picnic and ordering one to be delivered by
air, or running out of milk and deciding it is easier to use Prime Air than go to the supermarket.
Questions have also been asked about the security of drones packed with potentially high value goods,
which could prove tempting targets for the criminally inclined. Amazon doesn’t believe this will be an issue,
pointing out delivery trucks, which carry far more products than a single drone can, are not routinely victims of
crime. Whether the economics stack up or not, and Amazon clearly believes they do, how drones will work in the
existing aviation environment is the biggest challenge to their development.
‘Integration is the number one, two and three biggest problem for drones’, says a member of the Royal
Aeronautical Society’s unmanned aerial vehicle group. ‘Think of them like bikes on the road. It would be lovely
to have cycle lanes everywhere but it’s just not practical, they have to fit in with the cars and lorries.’
Perhaps more difficult will be working out how drones will operate in a complex urban environment, where
buildings can rise above the 400 ft ceiling, and hard-to-detect obstacles such as telephone wires are common.
The internet retailer is confident it can overcome such worries, but there is a host of other factors to consider.
Weather is one: wind and rain can have a huge impact on such small aircraft, making them hard to fly. Range
is another: although the drones’ current range of ten miles is expected to increase, Amazon would need to
massively expand its distribution network to hit the target of deliveries within thirty minutes. Physically getting
the packages into customers’ hands also raises questions.
These problems are all to be solved, but with Amazon’s might behind the project, there’s a good chance
solutions can be found.
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Source: Alan Tovey, ‘Can Amazon’s drones deliver the Back to the Future world?’, The Telegraph, 31 July 2016. © Telegraph Media Group Limited
6.4.1 The Strategy Canvas
To build a blue ocean strategy we use an analytical framework called the strategy canvas. The strategy canvas captures the range of factors which the industry competes on and invests in; the critical success factors, those factors
which are valued by the customer and which allow the company to compete in the industry. The horizontal axis of the
strategy canvas includes these critical success factors. On the vertical axis, we show the value a company offers the
buyers in terms of each of these critical success factors. A high score on the vertical axis means a company offers buyers
more, and therefore invests more, in that factor. We can then plot the current offering of a particular industry against all
these factors on our strategy canvas to derive a value curve. The value curve is a graphic representation of a company’s
relative performance across its industry’s critical success factors.
For example, NetJets Inc., a Berkshire Hathaway company, is the worldwide leader in private aviation, and manages
and operates the largest, most diverse private jet fleet in the world. Since its inception in 1996 it has grown to more
than 700 aircraft, which fly to more than 150 countries.33 NetJets created the blue ocean of fractional jet ownership,
which offers individuals and businesses all the benefits of whole aircraft ownership at a fraction of the cost. NetJets
created this blue ocean by looking across the alternative industries that compete for corporate travellers. They found
that corporate executives who want to fly are faced with two choices. They either travel first class or business class on a
commercial airline. Or, a company can buy its own corporate jet for executive travel. What NetJets did was to focus on
the key factors that cause companies to trade across these alternatives. By offering the best factors that commercial
airline travel and corporate jets can provide and eliminating everything else, NetJets provided customers with the
convenience of a private jet and the low costs of a commercial airline. This is shown in Figure 6.5.
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The Strategy Canvas of NetJets
High
Private Jet
Corporate travel
NetJets’ Value Curve
Commercial Airlines
First- and business-class business travel
Low
Price
(fixed
purchase
+ variable
price per
flight)
Need for
customers
to manage
airctaft
(aircraft
management
and administration)
Deachead
costs
Speed of total
travel time
Ease of travel
(including
check-in,
customs, etc.)
Flexibility
and
reliability
In-flight
service
For a discussion of blue ocean strategies and how an organization might create uncontested market
space, go to the online resources and see the Extension Material for this chapter.
www.oup.com/uk/henry3e/
6.5 Strategy Formulation in Turbulent Markets
If markets are becoming increasing turbulent and hypercompetitive, how can organizations formulate successful
strategies to achieve sustainable competitive advantage?34 The answer lies in a clearer understanding of the competitive conditions that operate in the marketplace, and the relationship between an environment’s turbulence and the
choice of strategy.
Clayton Christensen argues that the practices and business models that constitute advantages for today’s most successful companies only do so because of particular factors at work under particular conditions at this particular point
in time.35 He asserts that strategists need to get to grips with why and under what conditions certain practices lead
to competitive advantage. Christensen contends that even tacit knowledge that is difficult to imitate confers only
a temporary advantage. This is because scientific progress that results in better understanding has a tendency to
transform knowledge that once resided within an organization’s proprietary routines into explicit and replicable
knowledge. The task for organizations then is to be sufficiently aware of the factors which underpin their competitive
advantage such that they will know when old competitive advantages are due to disappear and how new ones can
be built.
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Figure 6.5 The Strategy Canvas of NetJets. Source: W. C. Kim and R. Mauborgne, Blue Ocean Strategy, Harvard Business Press (2005), p. 53
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There is an understanding that more attention needs to be paid to the differences between the strategies of dominant
incumbent players and those of challengers who are seeking to disrupt the current environment. By better understanding the interaction between strategy and the environment, managers can better tailor their strategies to the
environment, or better still, attempt to change the environment to their benefit. Richard D’Aveni argues that the firm
with strategic supremacy shapes the basis of competition for its rivals. It determines the rules on which rivals will
compete within the industry.36 For example, Gillette’s heavy investment in R&D put it at a disadvantage in a market
increasingly dominated by its competitor Bic’s disposable razors.
6
Instead of trying to compete according to industry rules that suited Bic, Gillette redefined the rules of the game
for razors. To achieve this, Gillette introduced its Sensor razor, which defined winning in terms of brand image
and shaving quality. This disruption of the competitive environment by Gillette continued with the introduction
of Mach3 razors. Gillette successfully changed the rules of the game, which in turn changed the competitive
environment. The new competitive environment is characterized by periods of stability punctuated by disruptions. Gillette deliberately disrupts the market with a new product offering for example, its Fusion razors with
flexball technology, and consolidates its gains around the new standard. The lesson to be acquired in these
hypercompetitive markets is that strategic paradigms that work well in one environment may not operate at all
in another.
D’Aveni argues market turbulence occurs within an industry as a result of competence-enhancing or competencedestroying disruptions. Competence-destroying disruptions occurs through events such as changes in customer
tastes, technological substitution, or obsolescence of a competence. In contrast, competence-enhancing disruptions make a market leader’s competencies more valuable. These competence disruptions can occur infrequently or
constantly. They result in four different competitive environments: equilibrium, fluctuating equilibrium, punctuated
equilibrium, and disequilibrium.37
●
Equilibrium. This environment is characterized by long periods of little or no competence-destroying turbulence.
Incumbent leaders exercise control through barriers to entry. A challenger must make these barriers to entry
irrelevant.
●
Fluctuating equilibrium. The environment is characterized by rapid turbulence based on frequent competenceenhancing disruptions. Challengers try to destroy the underlying core competencies of the leader and move the
environment to punctuated equilibrium or disequilibrium.
●
Punctuated equilibrium. This is characterized by brief dynamic periods based on discontinuous change or competence-destroying revolutions. This is particularly so in industries which experience fast technological change
followed by a dominant standard. The leader has to decide when and how to respond to the next revolution. The
challenger seeks to disrupt the stability sought by the leader.
●
Disequilibrium. This is the most challenging of the hypercompetitive environments, characterized by frequent
and discontinuous disruptions. The leaders will constantly be creating new competencies, and deliberately
disrupting themselves before their rivals do. Examples include Apple’s introduction of new iproducts, which
intentionally cannibalizes their existing product. The challengers have to disrupt this environment in ways that
cannot easily be matched or change the environment to become less disruptive.
By understanding the pattern of turbulence in their competitive environment, managers can develop better strategies
to ensure strategic supremacy.
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6.6 Disruptive Innovation and Strategy Formulation
Joseph Bower and Clayton Christensen’s work on disruptive innovations has resonance with Richard D’Aveni’s insights.38‘Disruption’ describes a process in which a smaller company with fewer resources is able to successfully challenge established
incumbent businesses.39 The smaller company is able to do this because incumbent businesses are focused on improving
products for their most demanding customers, which provides them with the greatest profit. These improvements in products by incumbent firms exceed the product performance needs of mainstream customers whilst ignoring the performance
needs of others. This provides an opportunity for entrants to target these neglected segments by offering them products
with more suitable functionality, invariably at a lower price. These entrants thereby gain a foothold in the market.
Incumbent firms, focused on the pursuit of higher profits in the more demanding segments, will invariably not
respond strenuously to the loss of a less profitable segment. Over time, entrants start to move upmarket and improve
the quality and performance of their product offerings to attract the incumbents’ mainstream customers. They do
this because moving upmarket also provides them with greater profitability. However, without the improvement in
quality to match the standards of mainstream customers they simply will not accept the entrants’ products, even at a
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Figure 6.6 The disruptive innovation model. Source: C. M. Christensen, M. E. Raynor, and R. McDonald, ‘What is disruptive innovation?’, Harvard Business Review,
vol. 93, no. 12 (2015), pp. 44–53
6
Figure 6.6 shows product performance trajectories (the red lines which show how products or services improve over
time) and customer demand trajectories (the blue lines which show customers willingness to pay for performance).
The incumbent firm is focused on improving products for their most demanding customers at the high-end of the
market; this is shown as Incumbent’s sustaining trajectory. In so doing, incumbents exceed the needs of the mainstream
customer segments whilst ignoring less profitable consumer segments. An entrant can seize the opportunity to target
these neglected segments. It offers them products with are simpler, more convenient, and invariably at a lower price,
which initially may be inferior to the existing technology of the incumbent. Over time, the entrant improves the performance attributes of its product offering and is able to compete with established products in their traditional markets.
This is shown as Entrant’s disruptive strategy in the diagram.
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low price. Once the quality rises enough to satisfy them, they gladly adopt the new product with its lower price. When
mainstream customers start adopting the entrants’ offerings in volume, disruption has occurred.
Christensen and Raynor argue the incumbent firm has the capabilities to succeed, but fails to use them effectively to deal with potential disrupters. This is because their resource allocations are designed to meet sustaining innovation needs. This makes them unprepared to respond to a different type of challenge. As we saw
earlier, the entrants lull the incumbent into a false sense of security by not competing with them for their best
customer; initially settling for low-end consumers. The trajectory of the disrupter will ultimately ‘crush’ the
incumbent.
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There is a great deal of confusion as to what constitutes disruptive innovation. The term is readily bandied about and
often used inappropriately.40 For example, Uber, the transportation company which uses mobile application to connect customers who require a taxi with taxi drivers, is often said to have disrupted the taxi business. Yet, according
to the criteria established by Christensen and his colleagues for disruption, Uber is not a disruptive innovation. This
is because Uber did not start by appealing to low-end or unserved consumers and then migrate to the mainstream
market, which is the pattern for a disrupter. Instead, Uber initially built a position in the mainstream market and only
then appealed to overlooked customer segments.
The disruptive theory differentiates disruptive innovation from sustaining innovations. Sustaining innovations make
good products better; disruptive innovations are initially considered inferior by an incumbent’s customers. Customers will not switch to the new offering simply because it is a lower price, but wait until the product quality improves
enough to satisfy their needs. When that happens, customers adopt the new product at a lower price, and disruption
occurs. On this basis, it is clear that Uber’s strategy is one of sustaining innovation rather than disruption. The reason
it is important to clearly define disruption theory is to enable managers to understand the different types of threats
that their business may encounter and respond accordingly. For example, small competitors on a disruptive trajectory
may pose a major threat whereas other small competitors may be safely ignored. The Case Example: Disrupting the
Competition for One Dollar at the end of the chapter shows how a small competitor disrupted the market for razor
blades.
6.6.1 Responses to Disruptive Innovation
There are a number of approaches that may help incumbent firms deal with disruptive innovators. These are:
1. Identify the strengths of your disrupter’s business model41
This is necessary because all disruptive innovations derive from business model advantages that can increase as
disruptive businesses move upmarket in search of more demanding customers. Identifying a disrupter’s business
model helps the incumbent identify what kinds of customers the disrupter might attract. The incumbent can
then determine how many customers of each kind it has which might be susceptible to disruption.
2. Identify your own relative advantages
An incumbent will need to know what is it that people want its company to do for them and what is it the disrupter could do better. This provides a clearer picture of the incumbent’s relative advantages. Where a disruptive
business offers a significant advantage and no disadvantages in performing the same activities as the incumbent,
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disruption will be swift and complete. This occurred with online music and CDs. When the advantages of a disrupter are less suited to performing the same activities as the incumbent and its disadvantages are considerable,
disruption will likely be much slower and easier to defend.
3. Identify the barriers a disrupter would need to overcome
Identifying the barriers a disrupter needs to overcome will enable the incumbent to see which activities within
their business are the most vulnerable to disruption and which parts they can defend. What the incumbent needs
to look for is barriers which are significant and difficult for the potential disrupter to overcome. The reason being
such barriers would tend to undermine any advantages the disrupter may possess.
4. Create a separate unit
The incumbent company may pursue its own innovation within the existing organization or set up a new unit
to achieve this. Where the existing culture and capabilities to undertake innovative change reside inside the
company it can be undertaken internally. Where innovative change marks a step change in how the company
operates, then it may be useful to set up a separate unit divorced from the existing culture. This unit would be
given entrepreneurial autonomy to develop and test new ideas.
Given the widespread discussion and pervasiveness of disruptive innovation, it is perhaps not surprising that it has
attracted criticism. Harvard historian, Jill Lepore, wrote in The New Yorker that disruptive innovation is no more than
a theory of why businesses fail.42 It cannot explain change or continuity. It is simply an idea forged in time which is
generalized from selected examples. John Kay concurs with Lepore, pointing out that the claims of Christensen and
his followers are inflated and tautological.43
Andrew King and Baljir Baatartogtokh argue that in explaining the success and failure across the seventy-seven
cases cited by Christensen and Raynor,44 other factors may be more appropriate than the theory of disruption.45 Their
research suggests the theory of disruption has little predictive power as to what may transpire in the market. They
conclude it is no substitute for careful analysis and making difficult choices.
Summary
Business strategy is concerned with how an organization is going to compete in its chosen industry or market. It deals
with individual business units that operate within an industry or distinct market segment. The aim of business strategy
is to achieve a sustainable competitive advantage.
In this chapter, we evaluated Michael Porter’s generic competitive strategies of overall cost leadership, differentiation, and focus. We noted that each strategy provides the means for an organization to occupy a defendable
position against the five competitive forces that determine industry profitability. Whether the organization pursues a low cost or differentiation strategy, it must choose which market segments it wants its products to compete
within.
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6.6.2 Limitations of Disruptive Innovation
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The resource-based view (RBV) has its primary focus upon the resources and capabilities within the organization. Proponents argue an organization should seek to match its internal resources and capabilities to the needs of the external environment. The RBV sees profit deriving from two sources: first, the sustainability of the competitive advantage that resources
and capabilities confer and, second, the ability of the firm to appropriate the profits (or rents) earned from its capabilities.
We discussed the role of competitive strategies within turbulent and hypercompetitive markets. We noted that market
turbulence can occur within an industry as a result of competence-enhancing or competence-destroying disruptions.
Finally, we discussed the role of disruptive innovations in which a smaller company with fewer resources can successfully challenge established incumbent businesses. And highlighted strategies for incumbent firms to avoid disruptive
innovations.
6
CASE EXAMPLE Disrupting the Competition for One Dollar
Over the past few years the male grooming market has continued to flourish as consumer product companies market everything from men’s hair loss shampoo to skin creams. Male grooming is still massively outsold
by female products, but what was essentially a niche product is now mainstream. Within the male grooming
market, the sale of razors continues to decline, not least because of the increasing popularity of men growing
beards. The US razor market has declined every year since 2013; in Western Europe sales of razors have fallen
every year since 2014.
The undisputed leader in the men’s razor market is Gillette; the world’s largest maker of razors. Gillette has
dominated this market for decades, with little interference. Its parent is the US multinational Procter & Gamble,
which operates in five key business segments. These are grooming; healthcare; beauty; fabric and home care;
and baby, feminine, and family care. In 2016, household brands such as Fairy washing up liquid, Ariel washing
powder, Gillette razors, and Pampers nappies generated revenues worldwide of over $60 billion. Almost half of
all revenue is generated in the US, around twenty-three per cent in Europe, and the rest is split between established and emerging markets.
In 2012, the male grooming market in the US began to change. Prior to this, Gillette ruled supreme, with its
constant innovations in blade technology. Its introduction of five blades razors, Fusion Proglide razors with
FlexBall technology, and lubricating razors are all aimed at winning more sales at higher prices. Not unlike computer printers; the printer was relatively inexpensive, but the ink cartridges were expensive, so it is with razors
and their indispensable blades. Thus, in 2012 Michael Dubin, fed up with the paying high prices for disposable
razors, founded Dollar Shave Club.
Dollar Shave Club offers its mostly male customers easy access to good quality razors via its subscription
service. Prior to Dollar Shave’s launch, personal care subscription services existed, but they simply supplied consumers with a surprise box of items based on what they thought were the customers’ preferences. What Dubin
did was to provide the consumer with exactly what was ordered. To start with, customers receive a razor handle
and a pack of razor blades. Thereafter, each month consumers receive replacement razor blades at their agreed
price of $1, $6, or $9, plus packaging.
Although Gillette remains the leader in razor technology and market share, arguably it failed to capitalize
on its position and scan the market for changes in consumer behaviour. That said, Gillette was thinking about
a subscription service for its razors, but did not launch Gillette Shave Club until September 2015. The irony is
Gillette had the idea before Dollar Shave Club launched, but its delay meant it was second to market. Clearly,
it used to be the big company eating the small company; now, it’s about the fast company stealing a march on
the slow.
By 2015, Dollar Shave Club had gone from zero to fifty-four per cent of the online shaving market. Despite
its massive marketing and R&D expenditure, Gillette Shave Club trails with an estimated twenty-one per cent.
At the same time, Gillette accused Dollar Shave Club of infringing its patented technology, as the competitive
rivalry intensified. The success of Dollar Shave Club is a result of offering simpler and cheaper razors, as well as
Dubin’s irreverent use of social media to mock his competitors’ products. He has tapped into a vein of consumer
resentment of paying over the odds for razor blades while lampooning his competitors. A YouTube video which
went viral with over twenty-four million views reminds consumers that the high price they pay for razors from
competitors goes to celebrities advertising the product.
Dollar Shave Club, along with a rival start-up called Harry’s, is taking market share from Gillette despite
the popularity of beards. But no competing subscription brand has managed to match Dollar Shave
Club’s rapid growth. In 2016, it had achieved over three million subscribers, with estimated revenues
of $200 million. This remarkable growth would not go unnoticed; it attracted both venture capitalists
and Anglo-Dutch multinational, Unilever. Impressed with Dubin’s business model of getting customers
to pay for his razor blades in advance and his management of the corporation, Unilever acquired Dollar
Shave Club for $1bn.
Importantly, the acquisition provides Unilever with a presence and capabilities it currently lacks in the
razor market. At a multiple of five times 2016 expected earnings, it didn’t come cheap, but then again, it has
managed five per cent of the men’s razor blade market since launching in 2012. Since 2010, Procter & Gamble,
which shelled out $57bn for Gillette in 2005, has seen its market share decline from seventy-one per cent to
fifty-eight per cent. Dollar Shave Club is gaining market share from what was always an intractable market,
dominated by Gillette, with its closest competitor, Edgewell Personal Care, achieving less than half of Gillette’s
market share.
Before Dollar Shave Club entered the market, the business model was based around the introduction of
new technologies to achieve a smoother and closer shave. This provided the justification for higher prices.
As it attracts consumers from the leading brands, Dollar Shave Club has also started to move its product
range upmarket, introducing premium brands. It offers shave butter and post shave cream. It also offers One
Wipe Charlies, for men’s toilet needs, again using social media fronted by Michael Dubin in his trademark
jocular style.
The global market for men’s razors and blades is worth around $15 billion, according to Euromonitor, about
one-fifth of which is in the US. Unilever, no doubt, expects to leverage Dubin’s capability of connecting directly
with the customer. In effect, the subscription model provides Unilever with an opportunity to bypass leading
retailers and perhaps even take on Amazon. With Unilever’s global reach, Dollar Shave Club can progress into
emerging economies such as Brazil and India, whose male grooming market should be worth an estimated
$620m by 2020.
What was once a market based on technological innovation is fast turning into a market based on customer
need and value.
169
6
CHAPTER 6 Business Strategy
170
PART THREE Strategy Formulation
Questions
1. How has Dollar Shave Club managed to disrupt the razor market?
2. Identify the extent to which Dollar Shave Club conforms to Clayton Christensen’s model of disruptive
innovation.
3. In which of Richard D’Aveni’s four competitive environments would these competence disruptions reside?
Sources: Lindsay Whipp, ‘Made-up men reflect changing $50bn male grooming industry’, Financial Times, 4 February 2017; John Murray Brown and Arash
Massoudi, ‘Unilever buys Dollar Shave Club for $1bn’, Financial Times, 20 July 2016; Lindsay Whipp, ‘Gillette sues Dollar Shave Club in cut throat battle’, Financial
Times, 17 December 2015; Lex, ‘Dollar Shave Club: smooth cut’, Financial Times, 20 July 2016; Lindsay Whipp, ‘P&G: a plot twist in the soap opera’, Financial
Times, 20 October 2015; Alan Livsey, ‘Dollar Shave Club wins market share and customers with back-to-basics approach’, Financial Times, 17 March 2017.
Review Questions
6
1. Comment on Porter’s assertion that an organization trying to pursue more than one generic strategy will
end up stuck in the middle.
2. Explain how an understanding of disruptive technologies may help an incumbent firm avoid the loss of
market share.
Discussion Question
If markets are hypercompetitive, this makes the use of business strategies redundant. Discuss.
Research Topic
Identify the many incarnations Apple’s suite of iProducts has gone through and state the extent to which each
incarnation is competence enhancing or competence destroying. How successful have competitors been in
rewriting the rules of the game set by Apple?
Recommended Reading
For a discussion of generic strategies see:
●
M. E. Porter, Competitive Strategy: Techniques for Analysing Industries and Competitors, Free Press, 1985.
For an understanding of disruptive innovations see:
●
●
J. Bower and C. M. Christensen, ‘Disruptive technologies: catching the wave’, Harvard Business Review, vol.
73, no. 1 (1995), pp. 43–53.
C. M. Christensen, M. E. Raynor, and R. McDonald, ‘What is disruptive innovation?’, Harvard Business
Review, vol. 93, no. 12 (2015), pp. 44–53.
CHAPTER 6 Business Strategy
171
For an insight into strategies in turbulent markets see:
●
R. A. D’Aveni, ‘Strategic supremacy through disruption and dominance’, Sloan Management Review, vol.
40, no. 3 (1991), pp. 127–35.
www.oup.com/uk/henry3e/
For more information and activities on business strategy, visit the online resources that accompany this book.
1
J. B. Quinn, Strategies for Change: Logical Incrementalism, Irwin, 1978.
2
See H. Mintzberg and J. A. Waters, ‘Of strategies, deliberate and emergent’, Strategic Management
Journal, vol. 6, no 3 (1985), pp. 257–72; also H. Mintzberg, ‘Learning 1, Planning 0’, California Management
Review, vol. 38, no 4 (1996), pp. 92–3.
3
The discussion of markets, industries, and strategic groups draw upon John Kay’s definitions. For further
explanation of what constitutes an industry and market, see Foundations of Corporate Strategy, Oxford
University Press, 1993, chapter 9.
4
The terms competitive strategy and business strategy can be used interchangeably.
5
M. E. Porter, Competitive Strategy: Techniques for Analysing Industries and Competitors, Free Press, 1980.
6
Porter, n. 5, p. 35.
7
For a discussion of value chains, see M. E. Porter, Competitive Advantage, Free Press, 1985.
8
Wayland, M. (2015), ‘Toyota’s per-car profits lap Detroit’s Big 3 automakers’, http://www.detroitnews.
com/story/business/autos/2015/02/22/toyota-per-car-profits-beat-ford-gm-chrysler/23852189/
whatever/.
9
The long-run average total cost (LRATC) curve represents the lowest unit cost at which any specific output
can be produced in the long run, when a company is able to adjust the size of its plant.
10
Porter, n. 5, p. 45.
11
See Porter, n. 5, p. 41.
12
See Porter, n. 5, p. 41.
13
E. M. Pertusa-Ortega, J. F. Molina-Azorín, and E. Claver-Corte, ‘Competitive strategies and firm
performance: a comparative analysis of pure, hybrid and ‘stuck-in-the-middle’ strategies in Spanish firms’,
British Journal of Management, vol. 20, no. 4 (2009), pp. 508–23.
14
R. M. Grant, ‘The resource-based theory of competitive advantage: implications for strategy formulation’,
California Management Review, vol. 33 (Spring 1991), pp. 114–35.
15
Grant, n. 14, p. 116.
16
R. R. Nelson and S. G. Winter, An Evolutionary Theory of Economic Change, Harvard University Press, 1982.
17
See D. A. Leonard-Barton, ‘Core capabilities and core rigidities: a paradox in managing new product
development’, Strategic Management Journal, vol. 13 (Summer 1992), pp. 111–25.
18
See R. M. Grant Contemporary Strategy Analysis, 9th edn, Wiley, 2016.
6
References and Notes
6
172
PART THREE Strategy Formulation
19
J. Barney, ‘Organizational culture: can it be a source of sustained competitive advantage?’, Academy
of Management Review, vol. 11, no. 3 (1986), pp. 656–65; J. Barney, ‘Looking inside for competitive
advantage’, Academy of Management Executive, vol. 9, no. 4 (1995), pp. 49–61.
20
M. B. Lieberman and D. G. Montgomery, ‘First mover advantages’, Strategic Management Journal, vol. 9,
no. 5 (1988), pp. 41–58.
21
C. Prahalad and G. Hamel, ‘The core competence of the organization’, Harvard Business Review, vol. 36, no.
3 (1990), pp. 79–91.
22
G. Hamel and C. K. Prahalad, ‘Strategy as stretch and leverage’, Harvard Business Review, vol. 71, no. 2
(1993), pp. 75–84.
23
This notion of a static framework is rejected by Michael Porter, see M. E. Porter, ‘What is strategy?’, Harvard
Business Review, vol. 74, no. 6 (1999), pp. 61–78.
24
C. W. L. Hill, ‘Differentiation versus low cost or differentiation and low cost’, Academy of Management
Review, vol. 13, no. 3 (1988), pp. 401–12; Pertusa-Ortega et al., n. 13.
25
A critique of generic strategies is provided by C. Campbell-Hunt, ‘What have we learned about generic
strategy? A meta-analysis’, Strategic Management Journal, vol. 21, no. 2 (2000), pp. 127–54.
26
Kay, n. 3.
27
See Kay, n. 3, p. 368.
28
M. E. Porter, ‘Towards a dynamic theory of strategy’, Strategic Management Journal, vol. 12, (Special Issue)
(1991), pp. 95–117.
29
Empirical support for the resource-based view can be found in R. Henderson and I. Cockburn, ‘Measuring
competence? Exploring firm effects in pharmaceutical research’, Strategic Management Journal, vol. 15,
(Special Issue) (1994), pp. 63–84.
30
W. C. Kim and R. Mauborgne, Blue Ocean Strategy, Harvard Business Press, (2005).
31
See Kim and Mauborgne, n. 30, p. 10.
32
See Kim and Mauborgne, n. 30, p.17.
33
https://www.netjets.com/Global/Media per cent20Portal/NetJets per cent20Fast per cent20Facts per
cent20February per cent202017.pdf.
34
For a discussion of whether sustainable competitive advantage remains a viable aim, see R. A. D’Aveni,
G. B. Dagnino, and K. G. Smith, ‘The age of temporary advantage’, Strategic Management Journal, vol. 31,
no. 13 (2010), pp. 1371–85; R. R. Wiggins and T. Ruefli, ‘Schumpeter’s ghost: is hypercompetition making
the best of times shorter?’, Strategic Management Journal, vol. 26, no. 10 (2005), pp. 887–911; R. McGrath,
‘Transient advantage’, Harvard Business Review, vol. 91, no. 6 (2013), pp. 62–70.
35
C. M. Christensen, ‘The past and future of competitive advantage’, Sloan Management Review, vol. 42, no.
2 (2001), pp. 105–9.
36
R. A. D’Aveni, ‘Strategic supremacy through disruption and dominance’, Sloan Management Review, vol.
40, no. 3 (1999), pp. 127–35.
37
See D’Aveni, n. 36.
38
J. Bower and C. M. Christensen, ‘Disruptive technologies: catching the wave’, Harvard Business Review, vol. 73,
no. 1 (1995), pp. 43–53. See also C. M. Christensen, The Innovator’s Dilemma: When New Technologies Cause
CHAPTER 6 Business Strategy
173
39
For a discussion of disruptive innovation and the misunderstandings surrounding its use, read C. M. Christensen,
M. E. Raynor, and R. McDonald, ‘What is disruptive innovation?’, Harvard Business Review, vol. 93, no. 12 (2015),
pp. 44–53.
40
Christensen et al., n. 39.
41
M. Wessel and C. M. Christensen, ‘Surviving disruptive: it’s not enough to know that a threat is coming.
You need to know whether it’s coming right for you’, Harvard Business Review, (2012), pp. 56–64.
42
J. Lepore, ‘The disruption machine’, The New Yorker, 23 June 2014.
43
J. Kay, ‘Innovation disrupted by warring gurus’, The Financial Times, 19 August 2014.
44
Christensen et al., n. 38.
45
A. King and B. Baatartogtokh, ‘How useful is the theory of disruptive innovation?’, Sloan Management Review,
vol. 57, no. 1 (2015).
6
Great Firms to Fail, Harvard Business Press, 1997; C. M. Christensen and M. Raynor, The Innovator’s Solution:
Creating and Sustaining Successful Growth, Harvard Business Press, 2003.
CHAPTER 7
CORPORATE STRATEGY
7.1 Corporate
Strategy
7.2 Growth
Strategies
7.3 Related
Diversification
7.4 Unrelated or
Conglomerate Diversification
7.5 Implementing
Growth Strategies
7.6 Portfolio
Analysis
7.7 Corporate
Parenting
7.8 Strategic Evaluation
Extension Material
Merits and demerits of
mergers and acquisitions
Main Reference
Goold, M., Campbell, A.,
and Alexander, M. (1994b).
Corporate Level Strategy:
Creating Value in the
Multibusiness Company.
Wiley, New York.
Learning Objectives
After completing this chapter you should be able to:
●
●
●
●
●
Identify different growth strategies
Evaluate related and unrelated diversification strategies
Discuss portfolio analysis
Analyse the role of corporate parenting in creating value
Discuss strategy evaluation
Extension Material
Buffet’s approach to adding
value
CHAPTER 7 Corporate Strategy
175
Introduction
In Chapter 6 we looked at business strategy and how an organization competes in its chosen markets. In this chapter
we turn our attention to corporate strategy. Corporate strategy is concerned with the question: what businesses do
we want to compete in? Where an organization is made up of multiple business units, a question arises as to how
resources are to be allocated across these businesses. How an organization determines which businesses to invest in
and which to divest is covered in this chapter. Clearly, the overall objectives of the organization will be paramount in
guiding these decisions. These objectives and, therefore, the overall direction for the organization are determined by
the corporate parent.
The role of a corporate parent is to add value across the business units. A measurement of the value being added by the
corporate parent is whether it is greater than if the business units were managed independently of the organization.
Where a corporate parent adds greater value; the organization is said to achieve synergy. In formulating a corporate
strategy, executives must be mindful of the organization’s internal resources and capabilities and how these meet
the changing needs of the external environment. The impact of corporate strategy on stakeholders, such as major
shareholders or trade unions, who possess sufficient power and influence to undermine the strategy, must also be
considered.
We noted in previous chapters that all organizations exist for a purpose. Once the purpose of the organization is determined, for instance to maximize shareholder value, the role of corporate strategy is to enable the organization to fulfil
that purpose. Therefore, corporate strategy defines the scope of the industries and markets within which the organization competes in order to achieve its purpose. Business strategy, in contrast, determines how it will compete successfully in those markets and contribute to the corporate strategy. The managers of a business unit will have considerable
autonomy to devise their business strategy. This reflects their knowledge of local markets, customers, and competitors. However, these managers must ultimately show that their business strategy contributes to the corporate strategy.
A corporate strategy sets the direction in which the organization will go. Even where the organization simply comprises a single business with only one or a few products, corporate strategy is relevant. The organization must still
consider the fundamental question of why it exists. And once the why (purpose) is answered, a corporate strategy
can be formulated that enables the organization to achieve its purpose. Where an organization is made up of many
businesses operating in different markets, corporate strategy is also concerned with how resources are to be allocated
across these business units. Clearly the objectives of the organization will be paramount in guiding these decisions.
These objectives and the overall direction of the organization are determined by the corporate parent.
A question at the forefront of corporate strategy is: how does an organization add value across the businesses that
make up the organization? This is the role of corporate parenting. A corporate parent exists where an organization
is made up of multiple business units. It refers to all those levels of management that are not part of customer-facing
and profit-run businesses within the multi-business organization. Corporate parents are often described as corporate
headquarters and derided as simply cost centres. This is because a corporate parent has no external customers and as
7
7.1 Corporate Strategy
176
PART THREE Strategy Formulation
such it cannot generate any direct revenues. Given that it incurs corporate overhead costs; the corporate parent must
demonstrate that these costs are offset by the tangible benefits it provides to the business units in the portfolio. The
question then becomes: what is the corporate parent doing which allows these businesses to perform better collectively than they would as stand-alone units?1
Corporate parenting is of benefit if the corporate parent adds greater value by its management and coordination of
these individual business units. The idea is that by effectively managing the related capabilities in each business unit,
as well as leveraging its management skills across these units, a corporate parent can achieve synergy. Synergy occurs
when the total output from combining businesses is greater than the output of the businesses operating individually.
It is often described mathematically as 2 + 2 = 5. For example, it can derive from economies of scale such as occur when
two business units decide to combine their manufacturing facilities, which results in lower unit costs. As a result, the
value of the combined businesses is greater than the value that can be derived from two separate businesses.
7.2 Growth Strategies
In order to grow, organizations can pursue a number of different strategies depending on the level of risk they are
prepared to countenance, their capabilities, and their management expertise. The organization might choose to direct
its energies to internal growth strategies or it may seek to diversify into other businesses. Igor Ansoff devised a matrix
to analyse the different strategic directions organizations can pursue.2
7
There are four strategies that an organization might follow: market penetration, product development, market
development, and diversification. These options are summarized below and shown in Figure 7.1:
●
Market penetration: increase market share in your existing markets using your existing products.
●
Market development: entering new markets with your existing products.
●
Product development: developing new products to sell in your existing markets.
●
Diversification: developing new products to serve new markets.
The first three strategies are particularly relevant to organizations that operate within the boundaries of an individual
business. However, an organization that seeks to broaden its scope of activities will be concerned with how it can best
diversify into different businesses. This issue of the multi-business organization is addressed in detail when we look at
diversification.
Product/Service
Market
New
Present
Present
New
• Market penetration
• Consolidation
• Liquidation
• Product development
• Market development
• Diversification
Figure 7.1 Ansoff’s growth vector matrix. Source: Ansoff, I. H. ‘Strategies for diversification’, Harvard Business Review, vol.35, no.2 (1957), pp.113–24. Reproduce
with permission of Harvard Business Review.
CHAPTER 7 Corporate Strategy
177
7.2.1 Market Penetration
An organization pursuing a strategy of market penetration seeks to increase the market share in its existing markets
by using its existing products. Its aim is to attract new consumers and get existing consumers to increase their usage
of the product or service. This strategy relies upon the organization’s existing resources and capabilities and, therefore,
is relatively low risk. To achieve market penetration, the organization will usually improve its product quality and
levels of service, backed by promotional spend. Its knowledge of both products and the markets should enable it
to respond more readily to changing consumer needs. When the market is growing; market penetration is relatively
simple to achieve. However, in a mature market, a strategy of market penetration implies taking market share from
your competitor which will invite retaliation. If demand conditions are insufficient to permit market penetration, the
organization must decide whether it can still retain its existing market share. Or, whether it would be wiser to exit the
industry. This strategy is shown in the first quadrant of Figure 7.1.
This strategy involves developing new products for your existing markets. The ability to innovate is crucial in developing products for rapidly changing consumer markets. A strategy of product development is necessary where organizations are faced with shorter product life cycles. In industries such as consumer electronics organizations are forced to
continually develop new products to maintain and grow their market share, and keep competitors on the defensive.
The phenomenal growth of Apple’s iPod, iTunes, and iPhone is testimony to the rewards that successful product development brings. A challenge is that new product development can be expensive and carries a greater risk of failure.
There is no guarantee that consumers will adopt the product. An organization that actively monitors consumers is
more likely to develop products that meet consumers’ needs. However, a more successful strategy is to develop products that create consumer need, as in Apple’s case.
7.2.3 Market Development
Market development involves entering new markets with the firm’s existing products. This may be done by targeting
new market segments and new geographical areas, or by devising new uses for its products. The existing product
may undergo some slight modification to ensure that it fits these new markets better. This is often the case where
certain social and cultural adjustments are made to ensure that the product more closely meets the needs of particular
geographical market segments. Many retailing organizations follow this route to growth. For example, the US giant
Wal-Mart, French retailer Carrefour, and UK retailer Tesco have all sought to enter new geographical markets with only
marginal changes to their product offerings. As with the previous strategies, market development builds on an organization’s existing resources and capabilities. Although the organization will have extensive knowledge of its product,
its experience of new markets will be less complete, thus increasing the level of risk.
7.2.4 Diversification
The fourth quadrant in the growth vector matrix is diversification. Here we are dealing with an organization that seeks
to broaden its scope of activities by moving away from its current products and markets and into new products and new
markets. Although this will involve the greatest level of risk, it may be necessary where an organization’s existing products
and markets offer little opportunity for growth. However, this risk can be mitigated by the organization diversifying into
7
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178
PART THREE Strategy Formulation
related businesses; that is, businesses that have some links with its existing value chain. In addition, broadening the scope
of the organization can help to spread risk by reducing the reliance on any one market or product. When the scope of an
organization takes it into unrelated markets, there may still be a sound business logic for the decision. This is particularly
true where a business is cyclical in nature. By diversifying into another business it may be possible to smooth these cycles so
that a peak period in one market coincides with a downturn in another market. This issue of the multi-business organization
are addressed in Section 7.3, when we discuss related and unrelated diversification.
7.3 Related Diversification
7
Related diversification refers to entry into a related industry in which there is still some link with the organization’s
value chain. Where an organization occupies a competitive advantage in an industry that is becoming increasingly
unattractive, it may wish to diversify into a related industry or market. The aim is to enter a market where there is a close
match with the capabilities that provide success in its current markets, and thereby generate synergy. For example,
Honda possess distinctive capabilities in engine design and manufacture. This allows Honda to leverage its capability
in engine production into related markets such as motorcycles, lawnmowers, and outboard engines. Related diversification can be separated into vertical integration and horizontal integration. Vertical integration occurs when an
organization goes upstream, towards its inputs, or downstream, closer to its ultimate consumer. The more control the
organization has over the different stages of its value chain, the more vertically integrated it is. Horizontal integration
takes place when an organization takes over a competitor or offers complementary products at the same stage within
the value chain. We can look at each of these in greater detail.
7.3.1 Vertical Integration
We can differentiate between two kinds of vertical integration. Vertical integration backwards occurs when an organization moves upstream towards its inputs. An organization may desire to have greater control over the inputs or
raw materials that go to make up its products. For example, the British supermarket retailer Morrisons grows many
of its own vegetables and is Britain’s biggest abattoir owner. Vertical integration allows it to be nimble in delivering
promotions on fresh food. Where the costs of inputs to its productive processes fluctuate, an organization may decide
that it is in its best interest to own these inputs. Similarly, an organization may feel it necessary to have control over
the quality of its inputs or may want to gain access to new technologies. Clearly, an organization must decide if the
value it derives from owning an asset is greater than the value to be derived from outsourcing it. In some instances,
the input will simply be too important to the organization for it to allow it to be outsourced.
Vertical integration forward occurs when an organization moves downstream towards its end consumers. In such a case,
an organization might acquire transport and warehousing to ensure its control over the channels of distribution to the
consumer. It may acquire retail outlets to ensure that it chooses where, when, how, and at what price its products are sold.
Whether the organization adopts vertical integration forward or backward, the end result is the same: it moves along its
value chain and secures greater control over its value-chain activities. Examples of vertically integrated companies occurs
in the oil industry. Companies such as ExxonMobil, Shell, and BP often adopt a vertically integrated structure allowing
them to operate along the supply chain from crude oil exploration all the way to refined product sale. A downside of
vertical integration is that the organization becomes increasingly dependent on a particular market and may be unable
to respond quickly to market changes.
CHAPTER 7 Corporate Strategy
179
7.3.2 Horizontal Integration
Horizontal integration occurs when an organization takes over a competitor or offers complementary products at
the same stage within its value chain. HSBC was able to acquire market share in the UK when it took over Midland
Bank. easyJet took over the budget airline Go! from British Airways and was quick to re-badge all of Go!’s planes with
easyJet’s own distinctive brand. The rationale for horizontal integration is efficiency savings through economies of
scale. By combining two separate organizations, it is argued that economies of scale can be achieved far faster than
through organic (internal) growth.
7.3.3 Transaction-Cost Analysis
According to Oliver Williamson, transaction-cost analysis implies that organizations should produce goods and services internally where the transaction costs of doing so is less than purchasing these on the open market.3 Therefore,
transaction-cost analysis provides a rationale for firms to assess whether to integrate vertically. For instance, when
organizations integrate vertically and operate at different points along their value chain, there may be a tendency
for them to be become too large and overly bureaucratic. Where the administrative costs of managing their internal
transactions are greater than the transaction costs occurring within the market, outsourcing these activities to a thirdparty specialist is a more efficient option. Where this is the case, the imposition of contracts ensures that third-party
producers supply products and services at an acceptable quality and price. Where transaction costs are much greater
than administrative costs, the organization may choose vertical integration.
Many organizations actively seek to outsource activities in which they add less value. The benefit is one of efficiency
gains achieved through outsourcing to a specialist provider and flexibility in being able to respond more readily to
market changes.
7.4 Unrelated or Conglomerate Diversification
Unrelated diversification refers to a situation where an organization moves into a totally unrelated market. It is sometimes called conglomerate diversification to reflect that it involves managing a portfolio of companies. The lack of any link
between existing markets and products and the diversified industry carries the greatest element of uncertainty and, therefore, risk. It may be that the organization’s management skills are sufficiently robust to provide it with a capability that can
be leveraged across different business units. This was certainly the case with the British conglomerate Hanson and BTR,
which experienced success in the twentieth century. As with all strategic decisions, the rationale for diversification needs to
be clearly thought out. Management complacency or poorly prepared analysis will simply multiply the likelihood of failure.
7
To understand transaction-cost analysis it is helpful to appreciate why organizations exist. Organizations exist because
they are capable of undertaking transactions more efficiently than individuals can in the marketplace. All transactions
undertaken between individuals, between firms, or between individuals and firms involve transaction costs. These
transaction costs include the search costs involved in making a purchase, such as the time involved in collecting information about the quality or price of a product, the costs involved in negotiating and drawing up a contract which tries
to cover as many eventualities as possible, and the costs of monitoring the other party to ensure their legal obligations
are fulfilled. In the event of the agreement being reneged upon, there is the cost of enforcement through the courts.
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PART THREE Strategy Formulation
A common reason for diversification is where an organization’s existing markets are saturated or declining. In such
a case, the organization will seek growth opportunities elsewhere. These opportunities may also more closely
reflect the organization’s development of its own capabilities. Another reason for conglomerate diversification
might be that regulatory authorities view vertical and horizontal integration by the firm as uncompetitive. A third
reason for diversification is that management may believe that by not having all their eggs in one basket (focusing
on one market or product range) they can diversify risk. If an organization operates across many different businesses, the failure of one business will not cause the company to collapse. By the turn of the century, firms had
internalized the mantra of ‘stick to the knitting’ as they began to de-layer, downsize, and divest themselves of all
non-core business activities.4
7
Michael Porter’s study of the activities of large prestigious US firms between 1950 and 1986 found that the majority of them
had divested more acquisitions than they had retained.5 Porter suggests the reason for some acquisitions is more often the
result of chief executives’ ego than the existence of a market opportunity. Constantinos Markides found that an organization’s decision to focus upon its core business is the most useful form of restructuring.6 Other research points to the increase
in the share price of parent organizations that sell off unrelated activities.7 This adds weight to suggestions that conglomerate diversification may be more in the interest of managers as agents rather than shareholders as principals. Hence the
stock market rewards organizations that divest themselves of unrelated diversification with a rise in share price, signalling
that this strategy is viewed as more appropriate for adding value.
Diversification may have become less popular, but there still remain stellar examples of successfully diversified firms.
The US giant GE is located in more than 170 countries and employs 333,000 people worldwide.8 Under the leadership
of chief executive and chairman Jack Welch, GE transformed itself throughout the 1980s and 1990s from a maker of
electrical appliances to a giant conglomerate. With his ‘number one, number two’ objective, Welch only operated or
acquired businesses which could be number one or number two in their market.9 Any businesses that did not perform or could not be improved to meet that objective were closed or sold. Welch changed the company’s focus away
from products towards high-value services and turned it into a global corporation. GE continues to operate a series of
diverse companies from power generation to financial services. (See Strategy in Focus 7.1 for a discussion of organizations that continue to follow a diversification strategy.)
7.4.1 Can Conglomerate Diversification Succeed?
Warren Buffett is chairman of Berkshire Hathaway which he runs with his business partner, Charlie Munger, and one of
the richest men in the world.10 Berkshire Hathaway is a diversified holding company and investment firm that includes
diverse interests in insurance, soft drinks, confectionery, furniture, restaurants, carpets, and plane rentals. His strategy
appears to have little to do with exploiting synergies across these businesses.
Between 1965 and 2016 Berkshire Hathaway experienced a compound annual return of nineteen per cent against
9.7 per cent for the S&P 500 index.11 During the Internet boom of the 1990s, when fund managers talked of the new
economy and a new investment paradigm, Buffett wisely sat out the fleeting dot.com era preferring instead to stick to
his old economy portfolio. This became one more reason for his richly deserved accolade, the Oracle or Sage of Omaha.
In 2016, Berkshire increased its per-share book value (which it prefers to earnings per share as a measure of performance) by 10.7 per cent; the S&P 500 index rose by twelve per cent, with dividends included.12 Over time, however, the
company has comfortably beaten the S&P 500 index.
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In engaging in conglomerate diversification, business leaders adopted the rationale that there exists a number
of companies that are poorly managed and underperforming. The aim then is to subsume these companies
within the conglomerate with a view to restructuring them to release value. In the UK, Hanson Trust and BTR
were industry giants that dominated the conglomerate game. In the 1980s Hanson regularly outperformed
the FTSE 100 with its ever-growing revenues and profit. BTR was seen as one of the best managed companies
into the 1990s. However, by the mid-1990s market sentiment had moved against these conglomerates, as
the environment in which both firms competed had begun to change beyond their theory of the business.
Undoubtedly leadership succession also played a role, as the calibres of the original leaders were difficult to
replicate.
Today diversified conglomerates, such as GE and Berkshire Hathaway in the US, still exist. In India, the
Tata Group has wide-ranging interests that include engineering, chemicals, consumer products, information
technology and communications, and energy, among others. As part of its desire to become a global group it
has acquired high-profile British companies such as Corus, the steel maker, and Jaguar Land Rover, as well as
Daewoo Commercial Vehicles in South Korea. The French company, PPR, tends to acquire related organizations
specializing as it does in retail shops and luxury brands, including the Gucci group. The Gucci Group itself owns
such luxury brands as Gucci, Balenciaga, Yves Saint Laurent, and Sergio Rossi.
Where a company is poorly managed and underperforming, restructuring it using cost controls and
customer-focused measures to release value may be relatively straightforward. However, as we will see later
in this chapter, a question that needs to be addressed is: can a parent company release more value from its
acquisitions (related or unrelated) than can be released by a rival organization? Or, to adopt a resource-based
view, can an acquirer deploy its distinctive capabilities effectively in an acquired business to release value? The
value created by an acquisition must outweigh the cost of the acquisition. Where a substantial bid premium has
been paid this becomes more difficult to achieve.
We might note that diversification is often rationalized by managers in terms of risk reduction. Yet if
shareholders require a diversified portfolio of shares they can achieve this far more cheaply than an organization
because the cost of buying shares in a company is cheaper than buying the company, which inevitably attracts
a bid premium. This is the reason many commentators argue that diversification is often in the interests of the
managers of diversifying companies, and not their shareholders.
Michael Goold and Kathleen Luchs point out that an assumption that the pursuit of synergy is the only rationale
for having a group of companies tends to contradict the available evidence.13 This suggests that not all corporations
should focus their management effort on acquiring and managing a portfolio of interrelated businesses. They argue
that the ultimate test of diversification is that the businesses in the portfolio are worth more under the management
of the corporate parent than they would be under any other rival organization. These ideas are developed in detail
when we discuss corporate parenting in Section 7.7. Their research indicates that conglomerate diversifications with
a sound rationale and clear vision can achieve synergy. A body of research exists that shows that unrelated diversification tends not to be as successful as related diversification.14 Nonetheless, this issue is not clear cut as Goold and Luchs
point out: ‘despite extensive research, empirical evidence on the performance of companies pursuing more and less
related diversification strategies is ambiguous and contradictory’.15
7
STRATEGY IN FOCUS 7.1 Conglomerate Diversification
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PART THREE Strategy Formulation
The examples of GE and Berkshire Hathaway show a carefully managed conglomerate can produce a sound growth
strategy. The Indian conglomerate, Tata Group, which owns Jaguar Land Rover successfully operates companies which
range from defence and aerospace to financial services. Richard Branson’s Virgin Group successfully manages companies from airlines and railways to telecoms and media.
For a discussion of Warren Buffett’s approach to adding value, go to the online resources and see
the Extension Material for this chapter.
www.oup.com/uk/henry3e/
7.5 Implementing Growth Strategies
We have seen that in pursuing a strategy of growth the organization is faced with either concentrating on its existing
markets or diversifying into new markets. We can now turn our attention to looking at how these different corporate
strategies can be implemented (see Figure 7.2). This includes mergers and acquisitions, internal developments,
joint ventures, and strategic alliances.
7.5.1 Mergers and Acquisitions
7
A merger occurs when two organizations join together to share their combined resources. A merger implies that both
organizations accept the logic of combining into a single organization and willingly agree to do so. Shareholders from
each organization become shareholders in the new combined organization.
An acquisition occurs when one organization seeks to acquire another, often smaller, organization. The acquisition
may be in the interest of both organizations, particularly where the acquiring company has substantial financial
resources and the firm to be acquired possesses proprietary technology, but needs funds to develop it further. The
acquisition may be in the form of shares of the new organization, and perhaps a cash payment. Where payment is only
in the form of cash, the acquired shareholders will no longer be owners. Clearly, where the shareholders feel the price
being paid for their shareholding represents fair value they will be more likely to concede ownership.16
Business growth directions
Related
(same industry)
Horizontal
(same stage in
supply chain)
Vertical
(different stage in
supply chain)
Forward (control
over customer
ordering)
Figure 7.2 Growth strategies.
Backward
(control over
its inputs)
Unrelated
(different industry)
Conglomerate
(few or no shared
competencies)
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However, where the acquisition is unwelcome and contested it is referred to as a takeover, specifically a hostile takeover. In
a hostile takeover, the board of directors of the takeover target is likely to say one of two things: first, that the offer being
made undervalues the organization and, therefore, should be rejected; second, that the strategies being proposed by the
takeover organization are incoherent and will not allow the true value embedded within the organization to be released.
The terms mergers and acquisitions are often used interchangeably, hence the term M&A, which is often seen in the
financial press.
Despite the rhetoric of the chairman of Cadbury, Roger Carr, who argued that were Kraft to succeed in acquiring Cadbury, it ‘would be absorbed into Kraft’s low growth, conglomerate business model’, this defence failed. In its £11.6 billion ($18.9 billion) takeover battle for Cadbury, the US food company Kraft was able to convince Cadbury’s shareholders
that it could release greater value for them than they were currently experiencing under their existing management.
In 2016 the UK supermarket, Sainsbury’s, took over Home Retail Group, which includes Argos and Homebase, for £1.4
billion. The rationale behind the deal was access to Argos’s home delivery and digital expertise. In addition, Sainsbury’s
expects cost savings from relocating Argos stores into Sainsbury’s supermarkets and click and collect points within
smaller convenience stores. Sainsbury’s is the UK’s largest non-food retailer. Some analysts questioned the logic of this
takeover given the competitive conditions that face supermarkets.
The disastrous takeover of Dutch bank ABN Amro by The Royal Bank of Scotland (RBS), the Belgian–Dutch bank Fortis and
Banco Santander of Spain is a salutary lesson. The consortium paid 71 billion euro ($98.5 billion; £49 billion) for part of the
Dutch lender—three times the book value. By the time RBS, then led by its chief executive Sir Fred Goodwin, had secured
the ABN Amro deal, the Dutch bank had sold on to Bank of America the asset which was most prized by RBS—its Chicagobased LaSalle unit. The price RBS paid for a lack of due diligence is the toxic assets it acquired with ABN and a reliance on
UK government bailouts. The Belgian–Dutch bank Fortis was nationalized by the Dutch government to avert a liquidity
crisis. In 2017 RBS was seventy-three per cent owned by the UK taxpayers and yet to make a profit since its bailout in 2008.
An organization may seek to implement a mergers and acquisitions route to growth for a number of different reasons,
for example, to enter new markets quickly or acquire capabilities it does not possess. A key issue with acquiring
another organization’s assets is whether value is being created or destroyed. Many mergers and acquisitions which
appear to exhibit sound business logic often fail miserably to live up to the pre-merger hype and expectations. A case
in point was the merger of Germany’s luxury car maker Daimler Benz with US automobile maker Chrysler to form
DaimlerChrysler. This was initially billed as a merger of equals. In fact, the merger with Chrysler cost Daimler Benz $36
billion (£18 billion) and an estimated $50 billion over the next ten years.17 Chrysler was eventually sold to private equity
group Cerberus in 2007. Daimler’s chief executive, Dieter Zetsche, conceded that the expected synergies between the
organizations had been over-estimated, arguing that US consumers had not been prepared to pay more for German
technology.18
7
In 2013 Microsoft acquired the handset and services business of Nokia for $7.2 billion in an audacious effort to transform
Microsoft’s mobile business. The deal was brokered by former Microsoft CEO Steve Ballmer, stating that Microsoft and
Nokia had not been as agile separately as they would be jointly, citing how development could be slowed down when
intellectual property rights were held by two different companies. Clearly, Microsoft executives thought buying their
way into the mobile market was faster and less expensive than building the business organically. By 2015 the deal had
soured, resulting in staff lay-offs and massive restructuring charges for Microsoft.
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PART THREE Strategy Formulation
If the objective of a merger and acquisition is to increase market share, one would expect the organization to engage
in a strategy of horizontal integration. Where the organization is concerned about its inputs, for example, we might
expect it to go upstream and engage in vertical integration. The major benefits to be derived from mergers and acquisitions are: (i) speed; (ii) market share; (iii) market entry; and (iv) rapid access to capabilities. The disadvantages of
mergers and acquisitions include: (i) paying a premium price for the acquired company and thereby increasing your
financial risk; also (ii) the problem of combining different cultures may not have been properly considered, such that
any reorganization is slow to release value to shareholders.
The legendary US investor Warren Buffett publicly derided Kraft’s takeover of Cadbury as ‘a bad deal’, stating that Kraft’s
use of its shares in the Cadbury deal was ‘very expensive currency’. Buffett, Kraft’s largest shareholder with more than
nine per cent of shares, argued that the £1.3 billion (£798 million) of reorganization costs and $390 million of deal fees
would mitigate any added value.
Porter suggests three criteria for increasing shareholder value in acquisitions:17
1. Attractiveness. An organization should be capable of achieving above-average returns in the target firm’s industry.
2. Cost of entry. This includes the capital sum paid for the acquisition, also costs such as the time it takes for management to integrate the organizations. The cost of entry should not be so expensive that it effectively prohibits
the organization from recouping its initial investment. This is all too often the case where management has paid a
high premium for an acquisition.
7
3. Competitive advantage or better-off. The acquisition must present an opportunity for competitive advantage
for the parent organization, or the acquired business. An organization should only consider other businesses to
acquire if substantial synergy can be achieved.
John Kay argues that added value or synergy is only forthcoming when distinctive capabilities or strategic assets are
exploited more effectively. As a result, a merger that results in the acquisition of distinctive capabilities that are already
being exploited adds no value.18
In 2016, Microsoft’s new CEO, Satya Nadella, placed the company’s biggest ever bet on an acquisition of LinkedIn, a
social network used by professionals to make contacts and change jobs. Although LinkedIn has in recent years lost
money, Nadella is buying access to billions of data points created when LinkedIn’s 433 million users interact.19
For more information on the merits and demerits of mergers and acquisitions, visit the online
resources and see the Extension Material for this chapter.
www.oup.com/uk/henry3e/
7.5.2 Internal Development
Another route to growth is internal development. This is sometimes referred to as organic growth (see Strategy
in Focus 7.2). It involves the organization using its own resources and developing the capabilities it believes will
be necessary to compete in the future. Many organizations start their growth trajectory using organic growth and
consider mergers and acquisitions as their industry matures. In reality, organizations simultaneously pursue a
strategy of internal development and simply capitalize on acquisition opportunities as they arise.
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The Benefits of Internal Development are:
(i) the organization experiences less financial risk;
(ii) it grows at a rate that it is able to control;
(iii) the learning that takes place within the firm is captured for its own benefit; and;
(iv) the organization does not need to use valuable resources trying to manage different cultures.
The Main Disadvantages of Internal Development are:
(i) the time it takes the organization to build up necessary strategic capabilities. Stalk reminds us that the ways in
which leading companies manage time represent the most powerful source of competitive advantage;20
(ii) with product cycle times reducing, a firm developing internally may not be able to exploit market opportunities;
(iii) where barriers to entry exist, a strategy of mergers and acquisitions may be necessary to enter the industry.
It’s nearly four years since German budget supermarkets Aldi and Lidl began in earnest their assault against
the established ‘Big Four’ British grocers. Both stores had been slowly growing in the UK for many years, but the
hubristic expansion of Tesco, Sainsbury’s, Asda, and Morrisons created a distinct opportunity. The mood among
shoppers had turned from range to convenience, while value was more important than ever. Burdened with a
network of half-populated hypermarkets, Tesco and the major competitors were therefore woefully unready for
the price war the expansive ‘discounters’ unleashed.
Their campaign was a great success. Aldi has overtaken the Co-Op to become Britain’s fifth biggest
supermarket by market share, according to data from Kantar Worldpanel, while Lidl is closing in on Waitrose
for seventh place (see Figure 7.3). In the twelve weeks to May 2017, Aldi commanded seven per cent of the
Market Share of UK Grocery Market 2017
30.0
25.0
20.0
15.0
10.0
5.0
0.0
Tesco
Sainsbury’s
Asda
Morrisons
Aldi
Figure 7.3 Market share of UK grocery market. Source: www.kantarworldpanel.com
Co-op
Waitrose
Lidi
Iceland
7
STRATEGY IN FOCUS 7.2 Aldi and Lidl’s Organic Growth
186
PART THREE Strategy Formulation
Aldi and Lidl UK Groceries Market Share
12.5
Market Share (%)
10
7.5
3.7
3.8
3
3.1
4
4.6
4.7
4.8
4.9
3.1 3.4
3.6
3.6
3.7
5.4
5.6
5.6 5.6
6
6.2
6.2
6 6.8
6.9
3.5 3.9
4.1
4.4 4.2
4.4
4.6
4.6
4.4 4.9
5
5
5
2.5
0
Jul’13
Jan’14
Jul’14
Jan’15
Jul’15
Aldi
Jan’16
Jul’16
Jan’17
Jul’17
Lidl
7
Figure 7.4 Aldi and Lidl UK groceries market share. Source: ‘Why Aldi and Lidl will keep on growing’, Management Today, 27 June 2017
UK grocery market, and Lidl was on five per cent. To put that in perspective, their combined share has grown
over eighty per cent since the summer of 2013 (see Figure 7.4). That’s billions extra passing through their tills
each year.
Every penny was wrenched from the hands of the Big Four, who have gutted their own margins in an effort
to stop the rot. The results for the major supermarkets show that for the first time in a while, all four of the major
supermarkets have grown sales. Morrisons achieved 1.9 per cent growth, Tesco 1.8 per cent, Sainsbury’s grew
by 1.7 per cent, while Asda expanded only 0.9 per cent.
Those who would hope Aldi and Lidl are just going to go away will be disappointed. The sales for Aldi were up
19.8 per cent and 18.3 per cent at Lidl, dwarfing the Big Four. More importantly, Aldi and Lidl have permanently
changed the dynamics of the grocery market by forcing down margins. While the big supermarkets can live with
that, albeit as less profitable entities than they once were, it means they will need to continue shutting their less
profitable stores to shore up their balance sheets. The discounters, on the other hand, have low prices built into
their business models from the beginning, emphasizing bulk over brand and price over range.
Without a depreciating UK property portfolio hanging around their necks, Aldi and Lidl remain well placed to
expand into the gaps their rivals are leaving. In November 2014, Aldi announced a plan to increase its store tally
from 450 to 1000 by 2022. It’s already more than one-fifth of the way there. Lidl, on the other hand, is investing
£1.5 billion over the next three years to build between forty and fifty stores annually (it has 650 as of April 2017).
To put that in perspective, Morrisons has just under 500 stores (though the stores are much bigger), while
Tesco has over 6,000, including its Express convenience stores. There’s clearly still a long way to go before the
discounters’ position in the market stabilizes, but until then they will continue to expand their geographical
reach and therefore market share.
If both German chains do indeed double their store numbers over the next several years, it wouldn’t be a
tremendous leap to expect their market share to increase accordingly, by which time the term ‘Big Four’ may no
longer be appropriate. It’s quite feasible to see Aldi and Lidl nipping at the heels of Morrisons before the decade
is over. Get ready for the Big Six.
Source: Adam Gale, ‘Why Aldi and Lidl will keep on growing’ Management Today, 27 June 2017. Reproduced with permission.
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7.5.3 Joint Ventures and Strategic Alliances
An organization may decide that it is in its interest to collaborate with one or more firms in order to achieve a specific
objective. The agreement between such organizations may only be temporary, and can range from the establishment
of a formal entity to a looser organizational arrangement. Collaboration continues to grow over time as organizations
recognize the benefits that cooperation may bring. A key reason for the expansion in cooperative ventures is the
growth in international markets. An organization that lacks the crucial market intelligence necessary to operate in
overseas markets stands a greater chance of success if it collaborates with an established overseas competitor.
Joint Ventures
A joint venture exists when two organizations form a separate independent company in which they own shares
equally. It is often formed when organizations feel it may be beneficial to:
(i) combine their resources and capabilities to develop new technologies;
(ii) gain access to new markets.
Organizations that are restricted from owning foreign assets outright may enter into a joint venture with a foreign
partner as a means of gaining access to inputs or lucrative markets. For example, as China and India continue to industrialize they seek to benefit from access to Western technology by entering into joint ventures. At the same time,
Western organizations gain access to massive consumer markets.
Strategic Alliances
Strategic alliances take place when two or more separate organizations share some of their resources and capabilities,
but stop short of forming a separate organization. The benefit is that each partner within the strategic alliance:
(i) gains access to knowledge it would not otherwise possess;
(ii) gains access to knowledge that would be expensive for it to develop;
(iii) reduces competitive rivalry.
A useful alliance will involve complementary resources and capabilities which allow both organizations to grow and
develop according to their strategic objectives. Gary Hamel and his colleagues argue that a strategic alliance may be
useful to strengthen both companies against outside rivals, even if in the process it weakens one of them vis-à-vis the
other.21 Therefore, alliances may be viewed as competition in a different form.
The ultimate aim of strategic alliances is to learn from your partners. The more focused companies view each alliance
as an opportunity to view their partners’ broad capabilities. They use the alliance to build new skills and systematically
diffuse all new knowledge they acquire throughout their organizations.
7
For example, the cost of developing a European long-haul airliner proved prohibitive for any one country. By entering into a collaborative alliance the UK, France, Germany, and Italy have formed the European Airbus consortium
and successfully developed the A380, the world’s largest passenger plane, at a greatly reduced risk. Each nation has
contributed its own distinctive capabilities to ensure that they develop a product which will successfully compete with
their US competitor, Boeing.
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PART THREE Strategy Formulation
Both joint venture and strategic alliances are less likely to succeed:
(i) when each partner’s objectives are unclear and not agreed;
(ii) when the working relationship is not based on trust.
Where managerial differences exist these must be resolved prior to entering into the joint venture or strategic alliance.
7.6 Portfolio Analysis
7
Corporate strategy is concerned with the question: what businesses do we want to compete in? Or, more accurately,
which markets have we identified in which we can effectively deploy our capabilities to provide competitive advantage? Where an organization is made up of multiple business units, the question concerns how resources are to be
allocated across these businesses. The subject of portfolio strategy is concerned with managing these strategic business units (SBUs) to decide which businesses to invest in and which to divest in order to maintain overall corporate
performance. This was the key decision facing Jack Welch when he was CEO and Chairman of GE.
A portfolio is simply the different business units that an organization possesses. Portfolio analysis allows the organization to assess the competitive position and identify the rate of return it is receiving from its various business units. By
­disaggregating the organization into its individual SBUs, the organization can devise appropriate strategies for each unit.
The aim is to maximize the return on investment by allocating resources between SBUs to achieve a balanced portfolio. In
effect, the parent organization assumes the role of a proactive investor or banker which manages its investment to achieve
the highest return based upon an acceptable level of risk. The two most widely used portfolio analyses are the Boston
Consulting Group (BCG) growth-share matrix and the General Electric business screen. We can look at each of these in turn.
7.6.1 Boston Consulting Group Matrix
This matrix was developed by the Boston Consulting Group and was widely used in the 1970s and 1980s. Since
then diversified organizations have largely fallen from favour as companies seek to focus upon their capabilities. The
BCG matrix plots an organization’s business units according to (1) its industry growth rate; and (2) its relative market
share (Figure 7.5). Industry growth rate can be determined by reference to the growth rate of the overall economy.
Therefore, if the industry is growing faster than the economy we can say it is a high growth industry. If the industry
is growing slower than the economy it is characterized as a slow growth industry. A business unit’s relative market
share (or competitive position) is defined as the ratio of its market share in relation to its largest competitor within the
industry. A business unit that is the market leader will have a market share greater than 1.0.
A key element of the BCG matrix is market share. The matrix draws heavily upon the experience curve. This suggests
that a high market share is a function of cost leadership achieved through economies of scale. This ability to reduce unit
costs comes through the accumulated experience the business gains competing within the industry. In Figure 7.5 each
business unit (or product) is represented by a circle and plotted on the matrix according to its relative market share and
industry growth rate. The size of the circle corresponds to the amount of revenue being generated by each business
unit. The lines dividing the portfolio into four quadrants are somewhat arbitrary.22 A high industry growth rate is put
at ten per cent, whereas the lines separating relative market share are set equal to the largest competitor, which is one.
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Relative market share
1.0
Question marks
Cash cows
Dogs
10%
Low growth
Industry growth rate
High growth
Stars
Market Share >1
1.0
Market Share <1
A business unit can fall within one of four strategic categories in which it will be characterized as a star, question
mark, cash cow, or dog. These classifications can then be used to determine the strategic options for each business
unit; that is, which business justifies further resource allocation, which generates cash for expansion, and which needs
to be divested.
●
Stars are characterized by high growth and high market share. They occupy the upper left quadrant of the matrix
and are the business leaders, generating large amounts of cash. They represent the most favourable growth and
investment opportunities to the organization. As such, resources should be allocated to ensure that they maintain their competitive position. At times stars may require funding in excess of their ability to generate funds, but
this will act as a deterrent to competitors. Over the long term, investment in stars will pay dividends, as their large
market share will enable them to generate cash as the market slows and they become cash cows.
●
Cash cows experience high market share, but in low growth or mature industries. Their high market share provides low costs, which produces high profits and cash generation. Their position in low growth industries means
that they require little in terms of resource allocation. The cash surpluses they generate can be used to fund stars
and question marks.
●
Question marks compete in high growth industries, but have low market share. They occupy the upper right
quadrant of the BCG matrix. Because they are in growth industries, question marks have high cash needs, but
they only generate small amounts of cash as a result of their low market share. The strategic options facing a
question mark are to make the investment necessary to increase market share and manage the business to a
star. Over time, it will become a cash cow as the industry matures. The other option is immediate divestment or
7
Figure 7.5 The BCG matrix. Source: B. Hedley, ‘Strategy and the business portfolio’, Long Range Planning, vol. 10, no. 1 (1977), p. 12. © 1977. Reproduced with
permission from Elsevier
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PART THREE Strategy Formulation
winding the business down with no further investment. In this way, the question mark may provide the organization with some residual cash flow in the short term.
●
Dogs have a low market share within a low growth industry. The lack of industry growth guards against allocating
further resources to a dog. Often the cash needed to maintain its competitive position is in excess of the cash it
generates. Organizations need to ensure that only a minimal amount of its business units occupy this position.
The strategic option is one of divestment.
According to Barry Hedley, the primary goal of a portfolio strategy should be to maintain the position of cash cows.23
The cash from the cash cows can then be used to consolidate the position of stars which are not self-sustaining. Any
surplus remaining can then be used to resource selected question marks to market dominance. An appropriate strategy for a multi-business organization is to retain a balanced portfolio. The cash generated by cash cows and the liquidation of question marks and dogs should be sufficient to support the organization’s stars and help selected question
marks achieve market dominance.
What portfolio analysis shows us is that the strategy being formulated for each business unit should correspond to its
position in the matrix. It should also align with the capabilities of the organization’s overall portfolio of businesses. For
instance, managers of stars should be accorded more recognition for maintaining market share. In contrast with stars,
managers of cash cows might be given higher profit levels to achieve as a more appropriate objective. The corporate
parent must ensure that its overall performance is not suboptimal as a result of inappropriate business unit objectives,
which lead to poor resource allocation decisions.
7
Criticisms of the BCG Matrix
The BCG matrix uses only industry growth rate and market share to assess a business unit’s current performance. In
particular, it overemphasizes the importance of market share and market dominance, which stems from its belief in
the experience curve. Its simplicity of use and persuasive results ensured a wide following throughout the corporate
world in the 1980s. However, the BCG matrix is a tool of analysis and, therefore, requires managers to use their judgement. It is not an excuse to suspend one’s judgement.
Prahalad and Hamel note: ‘major companies that have had the potential to build core competencies but failed to do so
because top management was unable to conceive of the company as anything other than a collection of discrete businesses’.24 Hamel and Prahalad lament what they call ‘the tyranny of the SBU’, arguing instead for the modern business
organization to be seen as a portfolio of competencies.25 Table 7.1 provides a comparison of the organization when
viewed in terms of SBUs and core competencies.
7.6.2 The General Electric–McKinsey Matrix
General Electric and McKinsey & Company developed a more comprehensive measure of strategic success. In contrast with the BCG matrix’s four quadrants, the General Electric (GE) matrix comprises a nine-cell matrix (Figure 7.6).
The axes comprise (1) industry attractiveness; and (2) business strength/competitive position. Unlike the BCG matrix
there is an attempt to broaden the analysis of a business unit’s internal and external factors. For example, industry
attractiveness includes factors such as industry profitability, market growth, and the number of competitors, among
others. Similarly, business strength and competitive position go beyond market share to include a wider analysis of
the organization’s internal strengths and weaknesses. This includes factors such as technological capability, product
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191
Table 7.1 The organization: SBU and core competence. Source: Reprinted by permission of Harvard Business Review. Two concepts of the corporation, from C.
K. Prahalad and G. Hamel, ‘The core competence of the corporation’, Harvard Business Review, vol. 68, no. 3 (1990). © 1990 by the Harvard Business School Publishing
Corporation. All rights reserved.
SBU
Core Competence
Basis for Competition
Competitiveness of today’s products
Inter-firm competition to build competencies
Corporate Structure
Portfolio of businesses related in product-market
terms
Portfolio of competencies, core products, and
businesses
Status of the Business Unit
Autonomy is sacrosanct; the SBU ‘owns’ all
resources other than cash
SBU is a potential reservoir of core competencies
Resource Allocation
Discrete businesses are the unit of analysis; capital
is allocated business by business
Businesses and competencies are the unit of analysis;
top management allocates capital and talent
Value Added of Top Management
Optimizing corporate returns through capital
allocation trade-offs among businesses
Enunciating strategic architecture and building
competencies to secure the future
As with the BCG matrix, each business unit is represented by a circle and plotted on the matrix. Each business unit (or
product) is also identified by a letter. The size of the circles relates to the size of the industry and the shaded portion
corresponds to the market share of each business unit. Each industry that a business unit operates within is graded on
a scale of 1 (very unattractive) to 5 (very attractive). By mapping each business unit against the factors management
believe to be important for success, each business unit can be assessed for its business strength and competitive position on a scale of 1 (very weak) to 5 (very strong).
Business strength/competitive position
Weak
Low
Industry Attractiveness
Medium
High
Strong
Figure 7.6 The General Electric–McKinsey matrix. Source: Adapted from ‘Enduring ideas: the GE–McKinsey nine-box matrix’, McKinsey Quarterly, September 2008
7
quality, and management ability, as well as relative market share. These are the factors that managers believe will be
important for achieving success.
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PART THREE Strategy Formulation
The GE matrix overcomes some of the more simplistic analysis of the BCG matrix. The inclusion of a nine-cell matrix helps
to broaden the criteria for assessing the performance of business units. Nonetheless, we should be aware that the analysis
can become complex. It is also subjective. The different criteria which are used to measure industry attractiveness and
competitive position are provided by the parent company. The parent company in turn uses these criteria to assess each
business. In effect, the parent corporation is stating what it believes to be important and simply assessing its strategic
business units according to this.
7.7 Corporate Parenting
7
In evaluating portfolio strategies,26 the role of the corporate parent in Section 7.6 is simply one of an investment manager; moving funds between businesses as it seeks to maximize its corporate returns. In contrast, Andrew Campbell
and his colleagues seek to understand how, and under what conditions, corporate parents succeed in creating value.
They argue that multi-business organizations create value by influencing or parenting the businesses they own. Sound
corporate strategies create value through parenting advantage. Parenting advantage occurs when an organization
creates more value than any of its rivals could if they owned the same businesses. For example, Unilever adds value by
sharing marketing and technological information across its business units in different countries. It also adds value by
providing funds to its SBUs for R&D, to enable new product development. Left to its own devices the individual business unit would simply under-invest in this area.27
The parent organization is seen as an intermediary between investors and businesses. In this respect, the parent competes against other parent companies and also against other intermediaries such as investment trusts. Therefore, the
corporate strategies make sense as long as the parent organization is able to create sufficient value to compete with
other intermediaries.28 If there is a good fit between the corporate parent’s skills and the needs and opportunities that
exist for its businesses, the corporation is likely to create value. However, if there is not a good fit, the corporation is
likely to destroy value. The concept of corporate parenting is useful in helping an organization to decide which new
businesses it should acquire. This is because unless the corporate parent is creating greater value than its costs, the
businesses would be better off as independent companies. In addition, it helps the corporate parent focus when deciding how each business should be managed.
In their influential book, subtitled Creating Value in the Multibusiness Company, Michael Goold, Andrew Campbell, and
Marcus Alexander argue that successful parents create parenting advantage through their value-creation insights.29 This
is an essential feature of successful corporate parents. It states that corporate strategies should be based on insights into
how they can create value in their portfolio of businesses. These insights tend to emanate from the corporate culture
as well as the experience of the chief executive and his or her management team. Parenting advantage also involves
creating a fit between how the parent operates—that is, the parent’s distinctive characteristics—and the opportunities
that exist within the business units. The key is not simply to identify some level of fit, but rather to achieve a closer fit
with its businesses than can be achieved by rival organizations. The idea of fit is a dynamic one, such that a fit in today’s
environment will not necessarily be a fit in tomorrow’s environment. This means corporate strategists need to be aware
of the trends occurring in the general environment that will have an impact upon their business units. One way in which
an organization might do this is scenario planning, which was discussed in Chapter 2.
To understand fully the fit between a parent and its various businesses the organization needs to analyse its parenting
opportunities and the critical success factors for each business (see Strategy in Focus 7.3).
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STRATEGY IN FOCUS 7.3 A Change of Corporate Parent
UK cereal brand Weetabix is to be snapped up by the US company Post Holdings in a deal worth £1.4 billion.
The breakfast cereal favourite, made in Britain since 1932, was put up for sale in January 2017 by China’s
Bright Food, which took a majority stake in 2012. Weetabix is made in the small town of Burton Latimer, near
Kettering, Northamptonshire, and will become part of the US’s third-largest cereal company. Other brands
owned by Post Holdings include Bran Flakes and Fruity Pebbles.
The Weetabix portfolio includes Alpen, the number one muesli brand in the UK, Ready Brek, Barbara’s, and
Weetos. The company employs about 1,800 people globally, with sixty per cent of the workforce in the UK. While
it has some overseas manufacturing plants, all of the wheat that goes into Weetabix biscuits is grown within fifty
miles of its base in Burton Latimer.
The deal is expected to complete in the third quarter of 2017 and gives Post access to the UK market through
an established brand, as well as an opportunity to find new markets for its own brands, including protein shakes
and bars. When Shanghai-based Bright Food bought Weetabix, it had hoped the cereal would become popular in
China as part of a general trend towards more western eating habits. However, while sales of Weetabix have risen
in China, market share has disappointed, as traditional rice and steamed bread remain popular breakfast staples.
Weetabix is exported to more than ninety countries, but the UK accounts for the majority of sales and the
brand is a royal warrant holder. It was family-owned until 2004, when it was bought by a Texas private equity
firm. It was later sold to another private equity firm, Lion Capital. Other potential suitors interested in Weetabix
were thought to have included the UK’s Associated British Foods, Cereal Partners Worldwide, and Italian pasta
maker Barilla.
Confirming the deal on Tuesday, Post Holding’s president and chief executive, Rob Vitale, said: ‘We have long
admired Weetabix as a leader in cereal and believe it will be a fantastic strategic fit within Post. Combining
together two category leaders [Alpen] continues our strategy of strengthening our portfolio in stable categories
7
Weeabix is one of the UK’s favourite breakfast cereals. Source: © Lenscap Photography/
Shutterstock.com
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PART THREE Strategy Formulation
and diversifying into new markets, bringing much-loved brands to significantly more customers globally. We
are excited about the growth opportunities that this acquisition brings.’
Giles Turrell, chief executive of Weetabix, said its new owners would help the company to grow. ‘The past
five years have seen us increase our branded sales at home and overseas. I’m confident Post Holdings will help
us open doors for continued expansion.’ Turrell will take on the new role of chairman of Weetabix and will be
responsible for managing the integration of the two companies. Turrell said job cuts were not expected in the
UK and that its new owners would allow the business to grow.
‘Post Holdings has no footprint or manufacturing in the UK’, he said. ‘As long as we remain successful in the
marketplace we will continue to manufacture at our plants here in Northamptonshire.’ An analyst said, ‘Weetabix
has struggled to crack the Chinese market, so it is no surprise to see Bright Food selling up.’
Post Holdings has annual revenues of $5 billion (£4 billion) and expects to make annual savings of about
£20 million a year before the third full year after completion of the deal, from shared administration and
infrastructure cost savings. It estimates that Weetabix will contribute about £120 million of earnings, excluding
any cost savings. Weetabix’s revenue was about £410 million in 2016.
Beyond the UK, Weetabix has operations in North America, South Africa, Germany, and Spain, and it is the
majority owner of a joint venture in Kenya that serves the African market. The UK and Ireland remain its biggest
market, followed by North America and China.
Source: Angela Monaghan, ‘Weetabix sold to US firm after breakfast cereal fails to catch on in China’, The Guardian, 18 April 2017. Reproduced with permission.
7
7.7.1 Parenting Opportunities
Each business unit contains opportunities for the parent to create value. It may be that the business unit does not have
a strong management team or lacks some specialized expertise, such as marketing. Each business will present the corporate parent with its own unique opportunities. Therefore, the issue is whether the business needs and opportunities
identified can be exploited by the parent company. In other words, do the parent’s capabilities fit with the needs and
opportunities of the business?
Each type of business will have different critical success factors which determine its success in the marketplace. In
one business, it might be the ability to develop innovative solutions for consumers. In another, it might be product
development and the speed to market. In order to create value the parent’s characteristics must be compatible with
the critical success factors needed for the business. This is crucial, since a misunderstanding of critical success factors
may lead the parent company to destroy value.
Successful corporate strategy requires parents which possess value-creation insights and distinctive parenting characteristics. And which focus on businesses where they can create value. There are four ways in which the corporate
parent can create value for their businesses: stand-alone influence, linkage influence, functional and services influence,
and corporate development activities.
1. Stand-alone influence. This concerns the parent company’s impact upon the strategies and performance of each
business the parent owns. Stand-alone influence includes such things as the parent company setting performance
targets and approving major capital expenditure for the business. There is an opportunity here for the parent to
create substantial value. However, where the parent imposes inappropriate targets or fails to recognize the needs
of the business for funds, it will destroy value.
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2. Linkage influence. This occurs when parents seek to create value by enhancing the linkages that may be present
between different businesses. For example, this might include transferring knowledge and capabilities across
business units. The aim is to increase value through synergy.
3. Functional and services influence. The parent can provide functional leadership and cost-effective services for
the businesses. The parent company creates value to the extent that they provide services which are more cost
effective than the businesses can undertake themselves or purchase from external suppliers.
4. Corporate development activities. This involves the parent creating value by changing the composition of its
portfolio of businesses. The parent actively seeks to add value through its activities in acquisitions, divestments,
and alliances. In reality, the parent company often destroys value through its acquisitions by paying a premium
which it fails to recover.30
Business strategy decisions are guided by their impact on competitive advantage. Similarly, corporate parenting proposes that the main criterion for corporate strategy decisions is their impact on parenting advantage. In this way, it
aims to provide a measurement for corporate-level decisions which might improve corporate strategies. Parenting
advantage—creating better value than one’s rivals—should be used to guide corporate strategy development. As
Campbell et al. state, ‘parenting advantage is the only robust logic for a parent company to own a business . . . parenting
advantage is the goal and criterion that should guide both the selection of businesses to include in the portfolio and the
design of the parent organization’.31
We can now turn to the question of which businesses the corporate parent should include in its portfolio. Michael
Goold and his colleagues suggest that businesses can be classified into five types: heartland, edge of heartland, ballast,
alien territory, and value trap.32
To determine which of the above five types a business falls within, two questions can be asked.
1. Do the parenting opportunities in the business fit with value-creating insights of the parent, such that the parent
can create a substantial amount of value?
2. Do the critical success factors in the business have any obvious misfit with the prospective parenting characteristics,
such that the parent might influence the business in a way that destroys value?
The answer to the first question will range from a high fit, where the value-creation insights of the parent fit well with the
opportunities in the business. To a low fit, where the value-creation insights of the parent company do not address the
important opportunities that exist within the business. Clearly, where the value-creation insights address all the important
opportunities in a business, there is no room for a rival to create superior value-creation insights. Where the degree of fit
between parent and business units is low, it is likely that another corporate parent would add greater value.
The second question requires the corporate parent to understand the critical success factors in the business and compare these with its own parenting characteristics. A misfit is likely to occur when the parent does not understand the
critical success factors of the business. It lacks a ‘feel’ for the business and, therefore, inadvertently influences the business in ways that destroy value. Those businesses that the parent does not understand well enough to ascertain the
extent of misfit should be categorized as having a high misfit.
7
7.7.2 Portfolio Decisions
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PART THREE Strategy Formulation
Low
Ballast
Heartland
Edge of
Heartland
MISFIT
of business’s
critical success
factors with
prospective
parenting
characteristics
Alien Territory
Value Trap
High
High
Low
FIT
of business parenting opportunities with
parent’s prospective value-creation insights
7
Figure 7.7 The parenting fit matrix. Source: A. Campbell, M. Goold, M. Alexander, and J. Whitehead, Strategy for the Corporate Level: Where to Invest, What to Cut
Back and How to Grow Organisations with Multiple Divisions, 2nd edn, 2014. © John Wiley & Sons Ltd. Reproduced with permission.
These business types are illustrated in the parenting fit matrix (Figure 7.7). This is divided into four quadrants. A business
will occupy one of these quadrants according to how well there is a fit between its needs and opportunities and the skills
of the corporate parent.
Heartland Businesses
These are businesses with needs and opportunities that the parent organization can address. The critical success factors of these businesses are clearly understood by the parent. Heartland businesses should be the main focus of the
company’s parenting. These are businesses the parent understands and can add the most value to.
Edge-of-Heartland Businesses
This can come about when a parent company acquires a new business that meets the value-creation insights of the
parent, but not all the heartland criteria. For example, the new business might be operating in markets with which the
parent is unfamiliar. In such a case the parent should recognize that its feel for the business is less certain and this might
require that it develop new parenting skills to deal with the business. The new business can be thought of as extending the boundaries around the heartland. The new business should be seen as an experiment in which the boundaries
of the heartland business are tested. This will involve greater risk than a heartland business but offer the upside of
substantial value creation. For example, Canon’s heartland includes businesses that involve precision mechanics, fine
optics, and microelectronics.33 However, Canon has extended its heartland to cover medical equipment, chemical
products, and office products.
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Ballast Businesses are those in which there are few opportunities for the parent company to add value. Most portfolios will contain a number of ballast businesses. Although the parent understands ballast businesses and they do not
present any misfits, the issue is likely to be one of opportunity cost. That is, as there are few parenting opportunities
the parent’s time and resources would be better spent on other businesses, particularly heartland businesses. Ballast Businesses may offer the corporation a useful cash flow, but ultimately the issue is: what effect does retaining a
Ballast Business have upon the rest of the portfolio? And, is it worth more to the parent company than to its rivals?
Value-Trap
Value-trap Businesses are businesses which appear attractive to the corporate parent on the surface but, in reality,
there exist areas of misfit with the parent. Value-trap businesses should be avoided and kept out of the corporate
portfolio unless the parent is capable of learning to reduce or eliminate the misfits.
Alien Territory
We should be aware that the parenting-fit matrix has its limitations. In line with similar portfolio tools of analysis,
it depends on the subjectivity of those making decisions as to what constitutes a good fit between the parent and
business units. Senior corporate managers spend less time with each business than their own managers do. In such
cases, their influence on these business units may be less soundly based than that of the managers who actually run
them. Furthermore, corporate headquarters encourage managers of business units to compete with each other for
resources. As a result, these managers will filter information going to the corporate parent in order to show their
business in the best possible light. Where this occurs some value will be destroyed, as the information on which the
corporate parent is making decisions is inevitably biased.34
There are similarities between parenting advantage and the resource-based view of core competencies.35 The key
divergence is the role given to the parent organization. According to the parenting advantage framework, the onus
is upon the resources and capabilities of the parent company, and how this is shared across the businesses.36 For the
resource-based view, the core competencies that reside within the parent organization and individual businesses are
not disaggregated, but treated as uniform.
To summarize, the best parents have value-creation insights about the most appropriate parenting opportunities and
focus their activities on trying to create added value from these insights. They possess distinctive parenting characteristics which enable them to create value. These will usually be superior to those of similar parents. Crucially, the
best parents primarily focus their portfolios on those business units where their parenting skills can create substantial
value—these are heartland businesses. They may make a conscious decision to invest time and resources in businesses which fall outside the heartland, such as ballast businesses. A point to bear in mind is that any such decision
should be based on a clear understanding that ballast businesses are worth more to the corporate parent than to rival
corporate parents. They should not be retained for emotional or historic reasons.
7
Businesses which do not fit with the prospective corporate strategy are said to be part of alien territory.
­Businesses which lie within alien territory offer the parent little opportunity to create value. The parent
­company’s ­value-creating insights are not relevant for such businesses and its parent characteristics do not fit
the businesses. They may be in the portfolio as a result of being part of another business that was acquired.
They are referred to as alien because their need is for a different corporate parent with a fundamentally different
­corporate strategy.
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PART THREE Strategy Formulation
7.8 Strategic Evaluation
We have addressed in this and in Chapter 6 a variety of different strategies that organizations can implement. The
question we now need to address is: how can the organization differentiate between the strategic options that it faces?
We might include a caveat here that it is unrealistic to expect any form of evaluation to identify a ‘best’ or optimal strategy. However, strategy evaluation can help to surface the implications of pursuing different strategic options before
they are implemented. One method is to assess the strategy according to its suitability, feasibility, and acceptability. We
can assess each of these in turn.
7.8.1 Suitability
An organization will be concerned to evaluate how well the strategy matches the needs identified within its strategic
analysis. There should be some consistency between the strategy, the opportunities within the external environment,
the capabilities of the organization, and the organizational objectives. For example, is the strategy capable of overcoming a threat identified in the external environment and mitigating any weaknesses in the organization? The strategy should leverage the organization’s capabilities to exploit external opportunities that may arise as a result of market
changes. The strategy should also meet the organization’s objectives which might be return on capital employed,
profit per employee, or customer satisfaction. It may include some combination of qualitative and quantitative measures as suggested by the balanced scorecard (discussed in Chapter 4).
7
7.8.2 Feasibility
Feasibility concerns whether a strategy will work in practice. An organization must ensure that it possesses the necessary
capabilities, such as finance, technological expertise, marketing, and other factors necessary to implement the strategy.
Where capabilities are deficient, can the organization develop these and achieve competitive advantage? As we have
seen, each industry has its own critical success factors. A strategy will not be tenable if it fails to meet these critical success
factors. These will include factors such as quality levels, price, product development, innovation, and customer support.
7.8.3 Acceptability
The criterion of acceptability addresses the response of stakeholders to the proposed strategy. Clearly, if a strategic change
is to be implemented, it must have the support of those who will be most affected by it. For example, managers of an SBU
often understand their business far better than staff at head office. However, a proposed strategy from an SBU which takes
into account local market conditions must also fit within the overall strategy set by the corporate parent. Similarly, stakeholders, such as institutional investors, will be particularly concerned about the impact of the strategy on profitability. Their
attentions will be drawn towards the return on capital employed, the cost–income ratio within the organization, and the
perceived levels of risk that arise from the strategy. Other stakeholders, such as employees, customers, and key suppliers,
will need to be assured that any changes will not negatively impact upon them. If the strategy is one of growth through
mergers and acquisitions, the organization needs to consider if this will be acceptable to the competition authorities.
The criteria of suitability, feasibility, and acceptability help managers to be explicit about any assumptions that may
underpin their strategies. In reality, it may be unlikely that an organization’s strategy fulfils all three criteria. In that case,
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the organization must decide on the strategy which fits its stated aims and objectives more closely. Inevitably this will
involve compromise.
Richard Rumelt proposes four tests of: (1) consistency; (2) consonance; (3) advantage; and (4) feasibility to evaluate
a strategy.37 He argues that any strategy can be tested for four types of critical flaw. These are briefly discussed
below.
1. Consistency. Any proposed strategy must not present mutually inconsistent goals and policies. For example, a
high-technology organization might face a strategic choice between offering a customized high-cost product
or a more standardized low cost product. Unless a choice is explicit throughout the organization, there may be
conflict between the sales force, the design team, manufacturing, and marketing.
2. Consonance. The test of consonance allows the organization to evaluate the economic relationships that characterize the business. It also helps determine whether or not sufficient value is being created to sustain the need
for the strategy over the long term. Consonance can include an assessment of why the organization exists, the
economic foundation which supports the business, and the implications of changes.
3. Advantage. This addresses whether an organization can appropriate sufficient of the value that it creates. A
strategy must create competitive advantage in one or more of the following three areas: superior skills, superior
resources, and superior position.
Summary
Corporate strategy is concerned with the question: what businesses do we want to compete in? Corporate strategy defines the scope of the industries and markets within which the company competes. Where a company is
made up of multiple business units, a role arises as to how resources are to be allocated across these businesses.
The purpose and objectives of the organization are paramount in guiding these decisions. Once the objectives
are determined, the role of corporate strategy is to enable the company to fulfil those objectives. The objectives
and, therefore, the direction of the organization, are determined by the corporate parent. The role of a corporate
parent is to add value across its business units. Where a corporate parent adds greater value, the organization is
said to achieve synergy.
In order to grow, organizations can pursue a number of different strategies. Each strategy carries a different level of risk
and is predicated upon an organization’s capabilities. Where an organization seeks to broaden its scope of activities it
will be concerned with how it can best diversify into different businesses. This may take the form of related or conglomerate diversification. The methods by which an organization’s corporate strategy can be implemented also differ. The
organization’s competitive position, cost implications, need for technology, speed, access to markets, and competitive
threats will all help to guide the decision on which methods it chooses to implement its strategy. A popular method
for assessing business performance is portfolio analysis. Two approaches include the Boston Consulting Group matrix
and the General Electric matrix.
7
4. Feasibility. Lastly, the criterion of feasibility is to ensure that any proposed strategy does not overtax an organization’s available resources or create insoluble problems for it. It is futile to formulate a brilliant strategy which the
firm is simply incapable of implementing.
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PART THREE Strategy Formulation
The corporate parenting approach suggests the parent company should use its value-creation insights and distinction parenting characteristics to identify a heartland of businesses to which it can add substantial value. In evaluating
strategies, executives must be aware of both the organization’s internal resources and capabilities and how these meet
the needs of the external environment. In addition, the opinions of stakeholders who have the power and influence to
affect strategy must be taken into account.
CASE EXAMPLE Throw Out the Knitting and Stick to
7
Vertical Integration
APPLE and Tesla are two of the world’s most
talked-about companies. They are also two
of the most vertically integrated. Apple
not only writes much of its own software,
but designs its own chips and runs its own
shops. Tesla makes eighty per cent of its
electric cars and sells them directly to its
customers. It is also constructing a network
of service stations and building the world’s
biggest battery factory, in the Nevada
desert.
A century ago this sort of vertical inteApple writes most of its own software and runs its own shops. Source: © Hadrian/
gration was the rule: companies integrated Shutterstock.com
‘backwards’, by buying sources for raw
materials and suppliers, and ‘forwards’, by buying distributors. Standard Oil owned delivery wagons and refineries in addition to oil wells. Carnegie owned iron-ore deposits and rail carriages as well as blast furnaces. In
his 1926 book Today and Tomorrow, Henry Ford wrote that vertical integration was the key to his success: ‘If
you want it done right, do it yourself.’ He claimed he could extract ore in Minnesota from his own mines, ship
it to his River Rouge facility in Detroit, and have it sitting as a Model T in a Chicago driveway—in no more than
eighty-four hours.
Today this sort of bundling is rare: for the past thirty years firms have been focusing on their core business
and contracting out everything else to specialists. Steelmakers sold their mining operations and car makers
spun off their parts suppliers. Controlling it all made sense, the argument went, when markets were rudimentary: when supplies of vital materials were limited or contractors could cheat you. As markets became
more sophisticated these justifications fell away. Thanks to globalization, companies could always find new
resources and better suppliers.
Yet a growing number of companies are having second thoughts. This is most visible in information technology. The industry’s leaders were at the heart of the contracting-out revolution. Vertically integrated companies
such as IBM outsourced as much as possible in order to lower costs. Upstarts such as Microsoft prospered by
focusing on a narrow—but exceptionally valuable—slice of the pie: the operating system of personal computers. Now many start-ups in Silicon Valley pride themselves for being ‘full stack’. But re-bundling can be found
everywhere, from fashion to manufacturing.
Reasons for the reversal abound, but five stand out. The most important is simplicity. Consumers are willing
to pay a premium for well-integrated products that do not force them to deal with different suppliers or land
them with components that do not talk to each other. They want to be able simply to press a button and let the
machine do the rest. This is largely why Apple opted for integration, as did Nest, a maker of wireless thermostats.
A second reason is that firms operating on the technological frontier often find it more efficient to do things
in-house. Companies that are inventing the future frequently have no choice but to pour money into new ventures, rather than buy components off the shelf. This explains Tesla’s ‘gigafactory’ for batteries: their availability is
the biggest constraint on the firm’s growth. Boeing tried to cut its production costs by outsourcing seventy per
cent of the production of its 787 Dreamliner to hundreds of different suppliers—more than any airliner before.
The result was a disaster: parts came in late; bits didn’t fit together; deadlines were missed. The firm reversed
course, bringing manufacturing back in- house and buying a factory.
A third reason is choice: the more the market has to offer, the more important it is to build a relationship with
customers. Netflix and Amazon now create their own television shows in order to keep their viewers from buying more generic content elsewhere. Harry’s, an American company that sends its subscribers a regular supply
of razors and shaving cream, spent $100m to buy a German razor-blade factory.
Choice is reinforced by speed: fashion brands such as Spain’s Zara have resisted contracting out everything. Instead, they operate their own clothes factories, employ their own designers, and run their own
shops. This gives them a big advantage: they can turn the latest trend into new products, often in small
batches, and have it in stores in a couple of weeks. Less vertically integrated brands such as Gap and
­American Apparel find they are stuck with yesterday’s creations because they cannot get supply chains to
produce new wares quickly.
And then there is a combination of old worries about geopolitical uncertainty and new worries about the environment. In 2014 Ferrero, an Italian confectionary-maker, bought Oltan Gida, which produces one-third of Turkey’s
hazelnuts, the vital ingredient in Nutella. In 2015 IKEA, a Swedish furniture company, bought nearly 100,000 acres
of forests in Romania and the Baltic region. Earlier this year ChemChina, a state-owned company, purchased Syngenta, a Swiss seeds and pesticides group, for $43 billion, driven by the government’s quest for food security. Cruise
companies such as Costa Cruises and Disney have bought islands in the Caribbean and the Bahamas so that they
can guarantee that their passengers will have somewhere empty and unspoiled to visit when they sail past.
Core Complexities
The renewed fashion for vertical integration will not sweep all before it. For the most mundane products the
logic of contracting out still reigns supreme. And today’s bundling is less ambitious than Henry Ford’s: Apple, for
instance, contracts out a lot of production to contract manufacturers such as Foxconn (though it keeps them on
a tight leash). Integration is also hard to pull off: Tesla lost some of its shine on 11 April when it recalled 2,700 of
its sport-utility vehicles because of a glitch. That said, striking the right balance between doing things in-house
and contracting things out is clearly much more complicated than it was in the days when Tom Peters and his
fellow gurus told companies to focus on what they do best and outsource the rest.
Source: ‘Keeping it under your hat’, The Economist, 16 April 2016. Reproduced with permission.
Questions
1. What are the benefits that derive from being a vertically integrated company?
2. How does transaction-cost analysis aid Apple and Tesla in their decision to make or outsource activities?
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Review Questions
1. If an organization’s portfolio of businesses comprises some dogs, what are the options open to it according
to the BCG matrix? State circumstances in which an organization might be prepared to tolerate dog
businesses.
2. Evaluate the different criteria a parent company can use to assess the value derived from its parenting
skills.
Discussion Question
1. If Warren Buffett is right, that only shareholders of target companies benefit from takeovers, why do
companies continue to bid for other organizations? Discuss.
Research Topic
Discuss the reasons for the failed takeover of Unilever by Kraft Heinz. Assess the impact on both organizations after
this event, paying particular attention to whether their corporate strategies have changed.
7
Recommended Reading
●
●
C. C. Markides and P. J. Williamson, ‘Related diversification, core competencies and corporate performance’,
Strategic Management Journal, vol. 15 (Special Issue) (1994), pp. 149–65.
A. Seth, ‘Value creation in acquisitions: a re-examination of performance issues’, Strategic Management
Journal, vol. 11, no. 2 (1990), pp. 99–115.
For a discussion of portfolio analysis and the growth share (BCG) matrix, see:
●
B. Hedley, ‘Strategy and the business portfolio’, Long Range Planning, vol. 10, no. 1 (1977), pp. 9–15.
For an understanding of the resource-based view and a critique of portfolio analysis with its focus upon strategic
business units (SBUs), see the influential article:
●
C. K. Prahalad and G. Hamel, ‘The core competence of the corporation’, Harvard Business Review, vol. 68, no.
3 (1990), pp. 79–91.
For a corporate parenting approach to corporate strategy which argues that a parent company should ensure
that the value it creates from its businesses is more than could be achieved by a rival organization, see:
●
M. Goold, A. Campbell, and M. Alexander, Corporate Level Strategy: Creating Value in the Multibusiness
Company, John Wiley & Sons, 1994.
www.oup.com/uk/henry3e/
Visit the online resources that accompany this book for activities and more information on corporate strategy.
CHAPTER 7 Corporate Strategy
203
1
M. Goold, A. Campbell, and M. Alexander, ‘Corporate strategy and parenting theory’, Long Range Planning,
vol. 31, no. 2 (1994), pp. 308–14.
2
A version of this matrix is found in H. I. Ansoff, The New Corporate Strategy, John Wiley & Sons, 1998, shown in
Figure 7.1.
3
O. E. Williamson, Markets and Hierarchies: Analysis and Antitrust Implications, Free Press, 1975.
4
T. J. Peters and R. H. Waterman, In Search of Excellence, Harper & Row, 1982.
5
M. E. Porter, ‘From competitive advantage to corporate strategy’, Harvard Business Review, vol. 65, no. 3
(1987), pp. 43–59.
6
C. C. Markides, ‘Diversification, restructuring and economic performance’, Strategic Management Journal,
vol. 16, no. 2 (1995), pp. 101–18.
7
M. Daley, V. Mahotra, and R. Sivakumar, ‘Corporate focus and value creation: evidence from spin-offs’,
Journal of Financial Economics, vol. 45, no. 2 (1997), pp. 257–81.
8
For information on GE’s business portfolio, see https://www.ge.com/about-us/fact-sheet.
9
R. Slater, ‘The new GE: how Jack Welch revived an American institution’, Irwin Professional Publishing, 1992.
10
http://indianexpress.com/article/business/richest-people-in-the-world-bloomberg-bill-gates-warrenbuffett-mark-zuckerberg-jeff-bezos-koch-brothers-2878601/.
11
Figures from http://www.berkshirehathaway.com/2016ar/2016ar.pdf.
12
See Berkshire Hathaway, http://www.berkshirehathaway.com/2016ar/2016ar.pdf.
13
M. Goold and K. Luchs, ‘Why diversify? Four decades of management thinking’, Academy of Management
Executive, vol. 7, no. 3 (1993), pp. 7–25.
14
H. Singh and C. A. Montgomery, ‘Corporate acquisition strategies and economic performance’, Strategic Management
Journal, vol. 8, no. 4 (1987), pp. 377–86; and C. C. Markides and P. J. Williamson, ‘Related diversification, core
competencies and corporate performance’, Strategic Management Journal, vol. 15 (Special Edition) (1994), pp. 149–65.
15
Goold and Luchs, n. 13, p. 15.
16
See A. Seth, ‘Value creation in acquisitions: a re-examination of performance issues’, Strategic Management
Journal, vol. 11, no. 2 (1990), pp. 99–115.
17
‘Daimler offloads Chrysler for $7.4bn: private equity deal ends miserable decade for German engineer’. Daily
Telegraph, 15 May 2007.
18
‘Happily never after mergers, like marriages, fail without a meeting of minds.’ Financial Times, 15 May 2007.
19
Porter, n. 5.
20
J. Kay, Foundations of Corporate Success, Oxford University Press, 1993.
21
M. Murgia, ‘Social media is for grown-ups, not teeny-boppers, now’, The Daily Telegraph, 15 June 2016.
22
G. Stalk, ‘Time—the next source of competitive advantage’, Harvard Business Review, vol. 66, no. 4 (1988), pp. 41–51.
23
G. Hamel, Y. Doz, and C. K. Prahalad, ‘Collaborate with your competitors and win’, Harvard Business Review,
vol. 67, no. 1 (1989), pp. 133–9.
22
B. Hedley, ‘Strategy and the business portfolio’, Long Range Planning, vol. 10, no. 1 (1977), pp. 9–15.
23
Hedley, n. 22.
7
References and Notes
7
204
PART THREE Strategy Formulation
24
C. K. Prahalad and G. Hamel, ‘The core competence of the corporation’, Harvard Business Review, vol. 68, no. 3
(1990), pp. 79–91.
25
G. Hamel and C. K. Prahalad, Competing for the Future, Harvard Business School Press, 1994.
26
A. Campbell, M. Goold, and M. Alexander, ‘Corporate strategy: the quest for parenting advantage’, Harvard
Business Review, vol. 73, no. 2 (1995), pp. 120–32.
27
R. Buchanan and R. Sands, ‘Creating an effective corporate centre: the influence of strategy on head office
role,’ European Business Journal, vol. 6, no. 4 (1994), pp. 17–27.
28
Campbell et al., n. 26.
29
M. Goold, A. Campbell, and M. Alexander, Corporate Level Strategy: Creating Value in the Multibusiness
Company, John Wiley & Sons, 1994.
30
Porter, n. 5.
31
A. Campbell, M. Goold, and M. Alexander, ‘The value of the parent company’, California Management
Review, vol. 38, no. 1 (1995), p. 91.
32
Campbell et al., n. 26.
33
Campbell et al., n. 26.
34
M. Goold, A. Campbell, and M. Alexander, ‘Corporate strategy and parenting theory’, Long Range Planning,
vol. 31, no. 2 (1994), pp. 308–14.
35
Prahalad and Hamel, n. 24.
36
Campbell et al., n. 26.
37
R. Rumelt, ‘The evaluation of business strategy’, in The Strategy Process, edited by H. Mintzberg, B. Quinn,
and S. Ghoshal, Prentice-Hall, 1995.
CHAPTER 8
INTERNATIONAL STRATEGY
8.1 Globalization or
Localization
8.2 International
Strategy
8.3 A Globalization
Framework
8.4 Types of International
Strategy
8.5 Entry Mode
Strategies
8.6 Porter’s Diamond of
National Advantage
8.7 The Myths of
Global Strategy
8.8 The Challenge of
Globalization
Extension Material
Benefits and
disadvantages of
globalization
Extension Material
Entry mode
strategies
Extension Material
Multidomestic
strategies
Main Reference
Palmisano, S.J. (2006). The
globally integrated enterprise.
Foreign Affairs, 85(3), 127–36.
Learning Objectives
After completing this chapter you should be able to:
●
●
●
●
●
Discuss different perspectives on globalization
Explain what motivates firms to expand internationally
Evaluate different types of international strategy
Assess the entry mode strategies for a multinational firm to enter international
markets
Critique Porter’s diamond, which seeks to explain the competitive advantage of
nations
206
PART THREE Strategy Formulation
Introduction
A crucial issue for organizations that operate across international borders is to what extent they can develop global
brands and global products for all markets. Or, conversely, to what extent must their international strategy recognize and adapt to international diversities based on, for instance, consumer preferences? Central to this issue
is the extent to which an organization believes globalization has led to a standardization of consumer tastes and
preferences and, therefore, homogeneous markets. Or, as others have argued, that important national differences
still exist which warrant that organizations provide different product offerings to different countries. Clearly, each
manager’s understanding of the changes taking place in the international environment will have an impact upon
the type of strategy their organization pursues. In the same way, the level of risk an organization is prepared to
countenance and the amount of control it requires over its international operations will determine the entry mode
strategy it adopts.
Another important issue is how globalization affects the organizational structure and processes within a firm; that is,
whether its existing structure is sufficiently flexible to enable the rapid dispersal of knowledge and distinctive capabilities across its borders. This is important if the organization is to achieve synergies and more readily cope with external
changes. In this chapter we discuss competitive advantage from an international perspective.
8
8.1 Globalization or Localization
Globalization refers to the linkages between markets that exist across national borders. These linkages may be economic, financial, social, or political—in effect, anything that leads to increased interdependence among nations. This
implies that what happens in one country has an impact on occurrences in other countries. In contrast, localization
implies that national differences between countries are important and that organizations must take account of these
differences in their product offerings, distributions, and product promotions if they are to be successful.
Theodore Levitt, a proponent of globalization, argues that a major driving force for convergence between nations
is technology.1 Technology has created a world in which consumers worldwide desire standardized products. The
national differences that existed have gone, and only corporations which realize this will be in a position to take
advantage of the huge economies of scale in production, distribution, marketing, and management that globalization brings. For Levitt, this spells the end for multinational corporations; that is, corporations that operate in a
number of countries and adjust their product offering to suit each country. It marks the ascendancy of the global
corporation—one that sells the same products to all nations in the same way, thereby achieving low costs through
economies of scale. As Levitt states, somewhat emphatically, ‘the world’s needs and desires have been irrevocably homogenized’. Coca-Cola and Pepsi soft drinks are examples of globally standardized products that easily cross
national borders.
Success in this globalized marketplace requires that organizations compete on price and quality, offering the
same products sold at home to international markets. It requires organizations to search for similarities that exist
in segments around the world in order to exploit economies of scale. Globalization and the resulting standardization of products both respond to homogenized markets and expand these markets by offering products at lower
CHAPTER 8 International Strategy
207
prices. In this respect, Levitt’s global corporation is a result of globalization, but is also the cause of continuing
convergence.
Contrary to Levitt’s assertions, Susan Douglas and Yoram Wind argue that success requires standardized products and
global brands; organizations can make greater profits by adapting products and marketing strategies to suit individual
markets.2 They point out that while there are global segments with similar needs, such as luxury goods, this is not a
universal trend. For example, Nestlé’s frozen food division, Findus, finds it necessary to market fish fingers to its UK
consumers and coq au vin to the French, reflecting an understanding of the importance of national differences. For
Douglas and Wind, ‘The evidence suggests that the similarities in customer behaviour are restricted to a relatively
limited number of target segments’ and ‘substantial differences between countries’ still exist.3
Geert Hofstede argues that the national varieties that exist between countries are likely to survive for some time.5
In contrast to the advocates of globalization, he sees a worldwide homogenization of people’s attitudes ‘under the
­influence of a presumed cultural melting-pot process’ as very far off indeed. Hofstede reminds us that:
Not all values and practices in a society, however, are affected by technology or its products There is no evidence
that the cultures of present-day generations from different countries are converging.6
Levitt, and Douglas and Wind, occupy opposite sides of the globalization debate. The debate is not academic, but pragmatic; the outcome affects corporations. For instance, if the world is becoming increasingly globalized, this impacts
upon the strategic choices facing organizations. If the world is becoming increasingly localized, a different set of strategic responses are required. What is often lost sight of in the globalization debate is its effects on the lives of ordinary
people. Clearly, one might take a utilitarian approach and argue that, on balance, a greater good is accomplished.
However, this often masks local tragedies.
When referring to a multinational corporation (MNC), we mean all organizations competing internationally. This is
different to Levitt who uses the term to characterize a particular strategic response. Similarly, Bartlett and Ghoshal
also use the term multinational corporation to define a particular strategic response. What these authors refer to as a
multinational strategy, we refer to as a multidomestic strategy.
8
Douglas and Wind also reject Levitt’s assertion that consumers worldwide are becoming more price-sensitive, trading product features for a lower price. Instead, they point out that a strategy of offering low prices does not lead
to a sustainable competitive advantage since it is readily imitated by competitors. In the same way, technological
innovations may lower a competitor’s cost structure and therefore its prices. As for economies of scale from supplying
a global market, Douglas and Wind state that technological improvements have actually allowed scale efficiencies
at lower levels of output. This means that organizations can service differences in national markets more efficiently.
Other impediments to globalization may also come from tariffs and import restrictions imposed by foreign governments. Even within the corporation, restrictions to globalization may arise from local managers of foreign subsidiaries
who see standardization as demotivating. It deprives them of their autonomy to make decisions based on their local
expertise. Therefore, Douglas and Wind argue that globalization is far from ubiquitous and that organizations would
be unwise to ignore national differences. A similar point is made by Pankaj Ghemawat who states that geographic and
other differences have not been superceded by globalization, but appear to be increasing in importance.4 He argues
that an understanding of regional strategies can help organizations boost their performance.
208
PART THREE Strategy Formulation
For further information on the benefits and disadvantages of globalization, visit the online
resources and see the Extension Material for this chapter.
www.oup.com/uk/henry3e/
8.2 International Strategy
What motivates organizations to pursue a strategy of international diversification? When a decision is made to expand
abroad, what are the different types of market entry open to organizations? We will see that some of these market
entry strategies coincide with the growth strategies we evaluated in Chapter 7. The motives for firms to expand internationally can be evaluated by looking at organizational factors and environmental factors. The organizational factors
occur within the firm while the environmental factors are exogenous, that is, outside the firm’s control.
8.2.1 Organizational Factors
The Role of the Management Team
8
The perception of the senior management team about the importance of international activities will play a role in the
decision of the organization to internationalize. This may arise from a saturation of the domestic market; for example,
the mobile phone giant Nokia was forced to expand beyond the confines of its domestic economy in Finland. Where
an organization faces large fixed costs, such as can be seen with R&D within the pharmaceutical industry, expansion
overseas allows it to achieve economies of scale by spreading its costs over greater units of output. Similar economies
of scope are achieved by firms which compete in the branded packaged goods industry, such as Proctor & Gamble and
Unilever. These firms have developed distinctive capabilities in managing and coordinating their marketing activities
worldwide.
The extent to which managers possess knowledge and experience of overseas markets will have a bearing on
their decision to expand abroad. Another factor will be the management perception of risks involved in overseas
activities. In fact, the perceived level of risk can be correlated with the different types of market entry undertaken.
We discuss entry mode strategies later in the chapter. An important consideration in deciding whether to internationalize will be the locational advantages that an organization might gain from its value chain. The various
activities that go to make up an organization’s value chain may be located in different countries to take account
of differential costs and other locational advantages that a country may possess. We discussed the value chain in
detail in Chapter 4. We will revisit locational advantages when we consider national differences as a source of
competitive advantage.
Firm-Specific Factors
These include the size of the firm and the international appeal of an organization’s product. Other things being
equal, the likelihood is that larger firms will internationalize more than smaller ones. This is not surprising given
that larger firms possess greater resources, produce greater capacity, and are therefore likely to require wider
market coverage to attain economies of scale. That said, some firms may be relatively small, but the nature of their
product offering may have an international appeal, such as software, in which case a small firm may quickly internationalize. Products or services which possess an international brand image and, therefore, international appeal,
CHAPTER 8 International Strategy
209
may explain why some firms expand internationally, for example Coca-Cola, Starbucks, and high-end fashion
goods such as Armani.
8.2.2 Environmental Factors
Unsolicited Proposals
An unsolicited proposal may come about from an organization being approached by a foreign government, distributor, or customer. The widespread use of communication technology leads to many companies receiving unsolicited
requests to expand abroad.
The ‘Bandwagon’ Effect
The bandwagon effect refers to organizations that follow competitors who have gone international. Clearly, organizations will not want to be seen to be missing out on new opportunities. In the same way, organizations may come to the
conclusion that a presence in an overseas market is desirable.
Attractiveness of the Host Country
8
The market size of countries and a favourable regime towards foreign direct investment will be attractive to organizations. The rising per capita incomes of China and India, coupled with populations that together make up one-third of
the world’s population, are proving an irresistible lure for many organizations.
Modern Beijing: the rising per capita incomes and high population of China are proving an irresistible lure for many businesses.
Source: © A. Aleksandravicius/Shutterstock.com
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PART THREE Strategy Formulation
8.3 A Globalization Framework
Sumantra Ghoshal proposes a framework that a multinational firm can benefit from when seeking to go global.7 As
part of this framework, he states three strategic objectives inherent to all multinationals:
1) The organization must achieve efficiency in its current activities.
2) It must manage the risks inherent in carrying out those activities.
3) It must develop learning capabilities that allow it to innovate and adapt to the future.
In order to gain competitive advantage the firm will need to undertake actions that enable it to achieve these three
objectives. These may involve trade-offs when multinational firms pursue goals that are conflicting. This is not a cause
for concern, as Ghoshal’s framework allows a multinational to differentiate between the benefits and costs of alternative strategies. An organization has three fundamental tools by which it can build competitive advantage.
1) It can exploit the differences in input and output markets that exist in different countries. For example, the cost of
employing a software engineer in India is many times cheaper than in the US, UK, or Europe.
2) It can benefit from economies of scale in its different activities.
3) It can take advantage of synergies or the economies of scope that derive from its diversity of activities.
Table 8.1 gives a summary of the strategic objectives of the organization and the sources of competitive advantage
open to the multinational corporation.
8.3.1 The Strategic Objectives of a Multinational Corporation
8
1. Achieving efficiency
The efficiency of an organization is the ratio of the value of its outputs to the costs of all its inputs.8 In other
words, the greater the ratio or the gap between an organization’s costs and the value it generates, the more
Table 8.1 Global strategy: objectives and the sources of competitive advantage. Source: S. Ghoshal, ‘Sources of competitive advantage’, Strategic Management
Journal, vol. 8, no. 5 (1987). © John Wiley & Sons Ltd. Reproduced with permission.
Sources of competitive advantage
Strategic Objectives
National Differences
Scale Economies
Scope Economies
Achieving efficiency in current
operations
Benefiting from differences in
factor costs—wages and cost
of capital
Expanding and exploiting
potential scale economies in each
activity
Sharing of investments and costs
across products, markets, and
businesses
Managing risks
Managing different kinds of risks
arising from market-or policyinduced changes in comparative
advantages of different countries
Balancing scale with strategic and
operational flexibility
Portfolio diversification of risks
and creation of side-bets
Innovation, learning, and
adaptation
Learning from societal differences
in organizational and managerial
processes and systems
Benefiting from experience—
cost reduction and innovation
Shared learning across
organizational components in
different products, markets, or
businesses
CHAPTER 8 International Strategy
211
efficient it is. The differentiation of its products from competitor offerings allows an organization to premium
price and, therefore, maximize the value of it outputs. Similarly, by pursuing low cost factors, such as wages or
more efficient manufacturing processes, the organization will minimize the costs of its inputs.9 In effect, this
allows a multinational corporation to configure its value chain to optimize the use of its resources.
2. Managing risks
The multinational corporation faces different types of risk. These include: macro-economic risks that are outside
its control, such as military conflicts; Political risks, which emanate from decisions taken by national governments;
Competitive risks that deal with the uncertainty about how competitors will react to its strategies, and, lastly,
Resource risks. Resource risks imply that the firm may not have or be able to acquire the resources it needs to
undertake its strategy. This might be because it lacks a particular technology. A key point to bear in mind is that
risks change over time, necessitating an awareness of the external environment.
3. Innovation, learning, and adaptation
Ghoshal argues that the multinational corporation, by virtue of the different and varied environments within
which it finds itself operating, is able to develop diverse capabilities and better learning opportunities than a
domestic based firm. Its diverse resource base may help the firm create innovations and exploit them in different
locations. However, what is actually required for learning to take place is the existence of learning as an organizational objective that is actively supported and encouraged by senior management utilizing requisite systems and
processes. In short, learning must pervade the organization’s culture if it is to manifest itself in innovation.
8.3.2 The Sources of Competitive Advantage
1. National differences
This deals with what are sometimes called locational advantages. Locational advantages derive from the
observed fact that different countries have different factor endowments that provide these countries with
­different factor costs. For example, Russia has an abundant supply of natural gas, whereas Japan has very little. As
a result of this factor endowment Russia is an exporter of natural gas whereas Japan is an importer. In the same
way, the activities that go to make up a multinational corporation’s value chain have different factor costs. The
aim of the multinational corporation, then, is to configure its value chain in such a way that each of its activities is
located in the country that has the lowest cost.
National differences may also arise because of the clustering of key suppliers or technology firms around a
particular location, for example, Silicon Valley in California. Increasingly, organizations in the UK from finance to
telecoms have set up call centres in India for dealing with customer service matters. This allows organizations to
exploit the cheap labour rates existing in India and keep their cost base down. This is fine as long as productivity
and quality levels do not offset the benefits of lower wages.
2. Economies of scale
The concept of economies of scale states that as a firm increases the volume of its output so it is able to achieve
a reduction in its unit costs. One reason for this is that as firms produce ever larger outputs so their learning
experience accumulates. This allows them to move down the experience curve, which in turn generates cost
reductions. The firm should configure its value chain in order to ensure that it achieves economies of scale
8
We mentioned earlier that there are three tools for achieving global competitive advantage. These are national differences, economies of scale, and economies of scope.
212
PART THREE Strategy Formulation
Silicon Valley, as viewed from Mission Peak Hill. Silicon Valley is a nickname for the cluster of high-tech corporations that operate here. Source: © Alexey
Ulashchick/Shutterstock.com
8
in each activity. This allows it to operate at the lowest point on its long-run average cost curve; its minimum
efficient scale.
3. Economies of scope
Economies of scope arise from an understanding that the cost of undertaking two activities together is sometimes less than the cost of undertaking them separately. For example, auto manufacturers use common platforms
when making different types of cars. This allows them to achieve smaller production runs at a relatively low cost
through economies of scope. This flexible manufacturing enables an organization to produce a customized offering for the consumer at relatively low unit costs. In managing its activities globally, the organization needs to use
all three sources of competitive advantage in order to simultaneously maximize its efficiency, risk, and learning.
As Ghoshal states, ‘The key to a successful global strategy is to manage the interactions between these different goals and means.’10
8.4 Types of International Strategy
When considering how to compete in international markets organizations are faced with a stark dilemma. On the one
hand, to what extent should they produce standardized products for sale in different countries utilizing the locational
advantages of low cost countries? On the other hand, to what extent should they produce differentiated products that
embody variations in local tastes and preferences, but incur greater costs? This is the debate between globalization and
CHAPTER 8 International Strategy
213
localization which we discussed in greater detail in Section 8.1, when we assessed the work of Theodore Levitt. We can
say, other things being equal, globalization provides for greater efficiency through economies of scale brought about
by standardization and locational advantages, while localization ensures that the organization’s products are responsive to and meet the needs of local preferences.
The issue of globalization versus responsiveness to local needs highlights four basic strategies open to the organization seeking to diversify its activities overseas. These are: (1) multidomestic; (2) international; (3) global; and (4)
transnational.
8.4.1 Multidomestic Strategy
Wal-Mart entered the German market with the acquisition of the Wertkauf and Interspar grocery chains. However,
despite generating sales of $2.5 billion a year, it never posted a profit. Critics of the US giant said Wal-Mart failed
to understand the different culture that exists in Germany. For example, an attempt to introduce ‘greeters’ in stores,
whose role was to smile at every customer, is thought to have been particularly unpopular. In addition, a lawsuit by
employees forced Wal-Mart to change part of an ethics manual that prevented romantic relationships between supervisors and employees. Although this practice was the norm in the US, German workers saw it as a violation of their
personal rights. Added to this, Wal-Mart found that its position of being the cheapest retailer in its markets was already
taken by Aldi. In an ironic twist, we now find Aldi investing in the US, intensifying competition in the grocery sector.11
For a further discussion of multidomestic strategies, visit the online resources and see the
Extension Material for this chapter.
www.oup.com/uk/henry3e/
8.4.2 Global Strategy
With a global strategy the organization seeks to provide standardized products for its international markets. If a multidomestic strategy accepts cost increases as the price for local differentiation, a global strategy consciously embraces
cost reductions as the benefit of manufacturing standardized products. An organization pursuing a global strategy will
have their manufacturing, marketing, and R&D centralized in a few locations. A combination of standardization with
centralized facilities and functions enables them to reap substantial economies of scale. Industry examples include
8
A multidomestic strategy is aimed at adapting a product for use in national markets and thereby responding more
effectively to the changes in local demand conditions. This assumes that each national market is unique and independent of the activities in other national markets. To this extent local managers are often given substantial autonomy to
determine how the product will meet the needs of local consumers. A benefit of this decentralized multidomestic
strategy is that value-chain activities can more closely reflect local market conditions. A disadvantage of a multidomestic strategy is that with increased variety come increased costs. Therefore, an important task for managers is to try
to determine the point at which differentiation increases an organization’s costs more than the value it adds for the
consumer. At this point differentiation fails to be appreciated by the consumer. In addition, a multidomestic strategy
tends to impede learning across country boundaries, as capabilities that reside within a given country are not automatically shared.
214
PART THREE Strategy Formulation
aerospace, pharmaceuticals, consumer electronics, and semiconductors. Firms such as Intel, Apple, and Boeing have
developed a global brand that crosses national borders. A disadvantage of a global strategy is that it may overestimate
the extent to which tastes are converging and fail to respond to important local differences. For example, the US
retailer Wal-Mart exited South Korea when it became clear that its hypermarket formula did not appeal to local tastes.
8.4.3 International Strategy
An international strategy is based upon an organization exploiting its core competencies and distinctive capabilities
in foreign markets. Local managers may be provided with some degree of autonomy in adapting products to suit local
markets, but this is likely to be at the margin only. The capabilities inherent within the organization will be centralized
in the home country. For example, the sports shoe manufacturer Nike has core competencies in design and product
development. These value-chain activities are based in the US, while other activities, such as manufacturing, take place
in Far Eastern countries like Thailand. A disadvantage of this strategy is that its concentration of some activities in one
country can leave it open to threats from currency appreciations. Also, the geographical distance and different cultures
often make it difficult to control production and quality. Finally, the lack of resources given to overseas subsidiaries can
lead to a demotivation of local managers as their autonomy to make important decisions is eroded. Table 8.2 shows
the organizational characteristics that relate to these three international strategies.
8.4.4 Transnational Strategy
8
Christopher Bartlett and Sumantra Ghoshal suggest, until recently, most organizations in worldwide industries were
faced with unidimensional strategic requirements.12 In any given industry, an organization could obtain success by
matching its resources and capabilities to achieve efficiency, or responsiveness, or knowledge transfer required by that
industry. That is, ‘company performance was based primarily on the fit between the dominant strategic requirement of
the business and the firm’s dominant strategic capability’.13
Figure 8.1 shows nine leading organizations in three worldwide industries, and maps the strategic requirements of
their industry against the strategic capability of the company. We can see from the diagram that Unilever, Matsushita,
and Ericsson are successful examples of a multidomestic, a global, and an international company, respectively. The less
successful companies include Kao, Japan’s competitor to Procter & Gamble, and Unilever. Kao’s dominant capability is
Table 8.2 Characteristics of multidomestic, global, and international companies. Source: Reprinted by permission of Harvard Business School Press. From
C. Bartlett and S. Ghoshal, Managing across Borders: The Transnational Solution, 2nd edn, 1998, p. 67. Copyright © 1989 by the Harvard Business School Publishing
Corporation. All rights reserved.
Organizational Characteristic
Multidomestic
Global
International
Configuration of assets and
capabilities
Decentralized and nationally
self-sufficient
Centralized and globally scaled
Sources of core competencies
centralized, others decentralized
Role of overseas operations
Sensing and exploiting local
opportunities
Implementing parent company
strategies
Adapting and leveraging parent
company competencies
Development and diffusion of
knowledge
Knowledge developed and
retained within each unit
Knowledge developed and
retained at the centre
Knowledge developed at the
centre and transferred to overseas
units
Dominant Strategic Requirements
of Industry
CHAPTER 8 International Strategy
Responsiveness
(Branded Packaged
Products)
Efficiency
(Consumer
Electronics)
Transfer of
Knowledge
(Telecommunications
Switching)
Unilever
Kao
Procter
&
Gamble
Philips
Matsushita
General
Electric
ITT
NEC
Ericsson
Responsiveness
(Multinational)
Efficiency
(Global)
Transfer of
Knowledge and
Competencies
(International)
215
Dominant Strategic Capability of Company
Figure 8.1 Industry requirements and company capabilities. Source: C. Bartlett and S. Ghoshal, Managing across Borders: The Transnational Solution, 2nd edn,
1998, p. 23. Copyright © 1998 by the Harvard Business School Publishing Corporation. Reprinted by permission of Harvard Business School Press. All rights reserved.
Today the search for a match between an organization’s capabilities and a single set of environment forces no longer
holds. This has been replaced by a more complex set of environment demands. Organizations operating in global
industries have to reconcile diverse and often conflicting strategic needs. In the past, companies could succeed with
a unidimensional strategic capability that emphasized efficiency, or responsiveness, or transferring knowledge and
core competencies. Whereas now, more and more industries are driven by the realization that neither a multidomestic,
nor an international or a global strategy, is sufficient. This is because industries are evolving towards what Bartlett and
Ghoshal term transnational industries.
A transnational industry is one in which an organization is confronted with multidimensional strategic requirements.
In other words, it must simultaneously achieve global efficiency, national responsiveness, and a worldwide leveraging of its innovations and learning. However, organizations are somewhat constrained in responding to these environment changes by their internal capabilities. These, in turn, are contingent upon their administrative heritage. In
seeking to adapt to the challenges of a changing international environment an organization needs to understand
what determines its administrative heritage. Administrative heritage includes a firm’s configuration of its assets, its
management style, and its organizational values. These are influenced by leadership, the home country’s culture, and
organizational history.
The administrative heritage will influence a firm’s organizational form as well as its capabilities. Thus, if we map administrative heritage to the three strategies discussed above we see that a multidomestic firm is structured to allow it
8
global efficiency and standardization. However, it has failed to understand the differences between markets, and this
lack of national responsiveness has prevented it becoming a global player. Interestingly, Bartlett and Ghoshal make
the observation that Kao’s lack of success informs us that Levitt’s assertion of homogeneous consumer needs is not yet
a reality. In contrast to Kao, the European company Unilever has been highly successful in this industry by recognizing
the need for local product differentiation and strategic responses.
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to decentralize its assets and capabilities such that its foreign operations are able to respond to national differences
between markets. An international firm is structured in a way that allows it to transfer knowledge and capabilities to
foreign operations that are less developed. Its foreign operations possess some autonomy to adapt new products and
strategies, but they are more reliant on the parent company for these new products and ideas, which necessitates
more coordination by the parent company than we see with a multidomestic firm. A global organization’s structure
allows for a centralization of its assets, resources, and responsibilities. The role of its foreign subsidiaries is to build
global scale. Unlike the multidomestic or international organization, the global organization has less autonomy to
adapt new products or strategies.
A transnational organization seeks to maximize the trade-offs between efficiency and responsiveness to local need by
redefining the problem. As Bartlett and Ghoshal state:
It seeks efficiency not for its own sake, but as a means to achieve global competitiveness. It acknowledges the
importance of local responsiveness, but as a tool for achieving flexibility in international operations.14
8
Therefore, a transnational strategy recognizes the benefits of efficiency that derive from the global company, the
response to local needs of the multidomestic firm, and the transfer of knowledge and capabilities across countries by
the international firm. However, where the transnational strategy differs from the other organizational forms is that
it neither dogmatically centralizes nor decentralizes, but instead makes selective decisions. That is, it recognizes that
some resources and capabilities are better centralized in the home country for economies of scale and protection
of the capability. For example, R&D is a capability that most organizations agree is best kept in the home country.
Other resources may be centralized, but not in the home country. For example, a production plant for labour-intensive
products which service global operations may be built in a low-wage economy such as Mexico. Access to a particular
technology may require centralization of activities in a specific country like the US. In the same way, other resources
may best be decentralized to create flexibility and avoid reliance on a single facility.
The managers of a transnational organization will centralize some resources in the home country and some abroad,
and distribute others between the organization’s various national operations. This leads to a far more complex configuration of resources and capabilities that are distributed, but also specialized. The dispersed resources are managed throughout the organization by creating interdependencies between the subsidiaries. This cannot be achieved
through existing organizational forms, but requires an integrated network. This integrated network emphasizes ‘significant flows of components, products, resources, people, and information that must be managed in the transnational’.15
In Figure 8.2, each of these four broad strategies are plotted according to the extent to which they reflect competitive
pressures to reduce costs and the extent to which there exists a need to adapt to local market conditions.
For the transnational organization, each activity within the firm’s value chain is undertaken in the location which
provides for the lowest costs. Its resources and capabilities can be leveraged worldwide. However, accomplishment
of this requires a move away from traditional organizational structures towards a different kind of corporate structure
which allows the organization to manage these complex interactions through integrated networks. The discussion of
the transnational organization, with its emphasis on internal resources and capabilities, has clear affinities with the
resource-based view of strategy discussed in Chapter 5. For the transnational organization, the key capability for success is not a choice between efficiency, responsiveness, or learning. It is the simultaneous attainment of all three that
allows the organization to remain competitive.
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217
Pressures to Lower Costs
High
Low
Global
Strategy
Transnational
Strategy
International
Strategy
Multidomestic
Strategy
Low
High
Pressures for Local Adaptation
Figure 8.2 International strategies.
8
To summarize, a global strategy allows a multinational firm to achieve low costs through economies of scale and a
coordinated strategy, but is unresponsive to the needs of local markets. The global organization is configured in a way
that allows no slack resources for overseas subsidiaries. This effectively curtails its ability and, therefore, motivation
to respond to local needs. This also prevents the global organization from accessing learning opportunities that exist
outside its home country. A multidomestic strategy is the polar opposite of a global strategy. With a multidomestic strategy, the organization responds effectively to local market conditions and customer preferences in different
countries. However, this level of differentiation means it is unable to achieve greater efficiency through low costs. Any
local innovations may simply be the result of managers trying to protect their turf rather than working towards the
corporate good.
An international strategy allows a parent company to transfer its knowledge and capabilities to other countries and
the devolution of some autonomy to overseas managers. Its configuration of assets make it less efficient than a global
company and less responsive than a multidomestic company. Lastly, an organization following a transnational strategy seeks to achieve the efficiency and local responsiveness inherent in the previous three strategies, but also to
leverage innovation and learning across countries. The idea is that its resources and capabilities can be leveraged
worldwide. However, in order to accomplish this, a different kind of corporate structure is required which allows the
organization to manage these complex interactions.
8.5 Entry mode Strategies
In this section, we address the different types of entry mode strategies that companies can use to enter international markets. Keith Brouthers states that in selecting an appropriate entry mode, organizations need to answer two
questions.16
1) What levels of resource commitment are they prepared to make?
2) What level of control over their international operations do they require?
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PART THREE Strategy Formulation
For instance, organizations may not be willing to commit resources in what they perceive to be high-risk countries.
In contrast, where the perception of risk in countries is perceived to be low, organizations may want control over the
operation. What is important is the organization’s perception of international risk. This determines the answer to these
two questions and drives the type of entry mode that an organization will choose.
Kent Miller, views international risk as consisting of three integrated parts: (1) the general environment; (2) industry;
and (3) firm-specific risks.17 Although these risks are also faced by firms which operate in the domestic environment,
the difference is that for the international firm, some of these risks are far greater.
General environmental risks refer to uncertainties that affect all industries within a given country in a similar way, such
as political risk. Industry risks refer to input market uncertainties; such as labour or material supplies. Firm-specific
risks include such things as uncertainties that arise as a result of employee disputes. These firm-specific uncertainties
exist in the domestic market, but organizations operating abroad have the added responsibility of undertaking their
activities in a different culture.
Therefore, when considering an international entry mode strategy, managers need to be aware of the totality of risks
since if they consider only one type of international risk, such as input market uncertainties, this may lead to adoption of an incorrect entry mode strategy. This is because the entry mode eventually adopted may result in unforeseen
problems arising because the other international risk issues were not considered.
We can evaluate some of the different entry mode strategies in detail. These are exporting, licensing, international
franchising, joint ventures and strategic alliances, and wholly owned subsidiaries.18
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8.5.1 Exporting
Organizations are naturally a little tentative about committing resources to new markets about which they have varying degrees of knowledge. Under these conditions an organization may initially want to limit its resource commitments abroad until it builds up more local knowledge and develops its capabilities. Exporting is where an organization
makes goods and services in the home country and sells them in other countries. It is attractive in as much as it provides an opportunity for an organization to acquire international experience whilst minimizing its risk exposure and
resource commitments. At the same time, it also allows an organization to gain economies of scale through increased
sales. A disadvantage of exporting is that it relies on local distributors, some of whom may be less than committed to
marketing and promoting the international firm’s products.
Figure 8.3 shows each entry mode strategy drawn against the degree of perceived risk and the amount of control
acquired. What is apparent is that the level of risk increases as the organization seeks to maintain more control over its
activities. Thus, exporting provides little perceived risk but little control, whereas a wholly owned subsidiary produces
total control but comes with substantial risk.
8.5.2 Licensing
Licensing can be seen as another way of gaining entry into overseas markets without large resource commitments. In
return for a fee, the organization grants the right to use its patent, trademark, or intellectual property. The advantages
CHAPTER 8 International Strategy
219
High
Level of Investment and Risk
Wholly Owned
Subsidiary
Joint Venture
Strategic Alliance
Franchising
Licensing
Exporting
Low
Low
High
Amount of Ownership and Control
Figure 8.3 Entry mode strategies.
of licensing are that it requires little capital and offers a relatively quick access to overseas markets. The disadvantages
of licensing are that it requires an appropriate licensee who may in time be able to imitate your product and become
a competitor.
Franchising is a form of licensing that is employed by many international companies such as McDonald’s, Benetton,
and Pizza Hut. Its popularity has grown considerably since 1970. It is a system largely pioneered by US companies. The
franchisor agrees to transfer a package of products, systems, and services that it has developed to a franchisee for a fee.
The franchisee provides local market knowledge and entrepreneurship. The franchisor is responsible for improving the
product, checking outlet quality, and promoting the brand. Unlike exporting, the host country may be more receptive
to this form of market entry, as it involves local ownership and employment.
A number of disadvantages can stem from franchising. For instance, unless trust and understanding exist between
both parties the franchise will underperform. As the franchisor is responsible for improving the product, the franchisee
may free ride abdicating responsibility for success to the franchisor. Furthermore, should the franchisee provide a poor
customer experience in one franchise this affects the reputation of the entire chain. To be successful, franchising needs
to be seen by both franchisor and franchisee as mutually beneficial.
8.5.4 Joint Ventures and Strategic Alliances
Joint ventures and strategic alliances were covered in detail in Chapter 7 when we discussed how organizations
implement growth strategies. We can briefly restate that a joint venture exists when two organizations form a separate
independent company in which they own shares equally (see Strategy in Focus 8.1). It is often formed when organizations feel it may be beneficial to combine their resources and capabilities to develop new technologies or gain access
to new markets. Strategic alliances take place when two or more separate organizations share some of their resources
8
8.5.3 International Franchising
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PART THREE Strategy Formulation
and capabilities, but stop short of forming a separate organization. The idea is that each partner within the strategic
alliance gains access to knowledge that it would not otherwise possess and that would be expensive to develop.
A useful alliance will involve complementary resources and capabilities that allow both organizations to grow and
develop according to their strategic objectives. The ultimate aim of strategic alliances is to learn from your partners.
Both joint ventures and strategic alliances work well when each partner’s objectives are clear and agreed, and when
the working relationship is one based on trust. The disadvantage occurs when managerial differences exist as these
must be resolved prior to entering into a strategic alliance. Such problems are compounded when there is the potential for state interference. For example, the French food giant, Danone, and HSBC encountered state interference in
their joint ventures in China.19
STRATEGY IN FOCUS 8.1 Joint Venture between
Pharmaceutical and Technology
8
The UK’s biggest drug company and Verily Life Sciences, a division of Alphabet, have teamed up to tackle chronic
conditions.
GSK has been working on bioelectronic medicines since 2012 in a push to develop new
patentable treatments. Source: © 360b/Shutterstock.com
GlaxoSmithKline (GSK) has teamed up with Google’s parent company Alphabet to develop miniature electronic
implants for the treatment of asthma, diabetes, and other chronic conditions. GSK, Britain’s biggest drug company,
said it would form a joint venture with Verily Life Sciences, a division of Alphabet, to work on research into
bioelectronic medicines. GSK will own fifty-five per cent of Galvani Bioelectronics, and Verily will hold forty-five
per cent.
Galvani will be based at GSK’s global research and development centre at Stevenage, Hertfordshire, just north
of London, and will have a second research hub at Verily’s base in San Francisco. The companies will combine
their existing intellectual property rights and invest up to £540 million over seven years if the collaboration
meets certain goals. GSK has been working on bioelectronic medicines since 2012 in a push to develop new
patentable treatments as its Advair respiratory treatment faces competition from generic versions. It has
invested $50 million (£38 million) in a venture capital fund for bioelectronics and provided funding for scientists
outside the company working in the field.
Bioelectronic remedies attach battery-powered implants the size of a grain of rice or smaller to individual
nerves to correct faulty electrical signals between the nervous system and the body’s organs. GSK believes
altering these nerve signals could open up the airways of asthma sufferers, reduce inflammation in the gut from
Crohn’s disease, and treat patients with a range of other chronic ailments such as arthritis. So far, the implants
have only been tested on animals, but the aim is to produce treatments that supplement or replace drugs that
often come with side effects.
GSK and Verily, renamed from Google Life Sciences in December, said their collaboration would combine
GSK’s drug development and understanding of disease biology with Verily’s expertise in miniature electronics,
data, and software for clinical purposes. The new company will initially employ about thirty scientists, engineers,
and doctors.
GSK’s head of bioelectronics, said an advantage of bioelectronics would be that researchers should be able to
apply it to more diseases as the technology develops. He said working with Verily would speed up this process
and that he hoped to conduct the first tests on humans within three years.
‘We have to figure out how to interface devices with the small nerves in our bodies to find a new way to
deliver therapies. We will build the tiny devices that lie at the centre of bringing these treatments to potential.’
‘The smaller the devices the less they will need to be charged and the more precise they are, and the more
attractive this will be as an intervention. Hopefully in 10 years there will be a treatment option where your
doctor will say, “Why don’t you go for bioelectronic?”, and a surgeon will do a little procedure and it will help the
organ to do what it should be doing.’
GSK’s chairman of global vaccines, will chair the new company’s board, which will also include Verily’s chief
executive, and GSK’s head of bioelectronics. Galvani is named after Luigi Aloisio Galvani, an eighteenth-century
scientist whose study of a frog’s reactions paved the way for the study of neuroscience. GSK said it would invest
£275 million in its UK operations. Verily is one of Alphabet’s most important long-term ventures. It is part of
the tech giant’s lossmaking ‘other bets’ division that also includes Nest, which develops household products
connected to the internet.
Verily’s chief technology officer, said: ‘This is an ambitious collaboration allowing GSK and Verily to combine
forces and have a huge impact on an emerging field. Bioelectronic medicine is a new area of therapeutic
exploration, and we know that success will require the confluence of deep disease biology expertise and new
highly miniaturised technologies.’
Source: Sean Farrell, ‘Google and GSK form venture to develop bioelectronic medicines’, The Guardian, 1 August 2016. Reproduced with permission.
8.5.5 Wholly Owned Subsidiaries
Where an organization seeks to have total control over its operations abroad, it will choose a wholly owned subsidiary
as its market entry mode. There are two types: a greenfield site, in which the firm sets up a new operation; or, the firm
may acquire or merge with an existing organization abroad. Both types of entry involve the greatest commitment of
resources and, therefore, the most risk. The advantage is that this type of entry strategy also generates the greatest
returns. The downside is that there is no one with whom to defray the costs. This type of strategy is also referred to as
foreign direct investment (FDI). Organizations which use a direct investment strategy include Nestlé, Procter & Gamble, and General Motors.
Where an organization possesses unique resources and distinctive capabilities which provide for competitive advantage,
it will be more inclined towards a wholly owned subsidiary. For example, Japanese auto makers like Toyota and Nissan
tend to set up wholly owned subsidiaries abroad. Further, FDI may attract support from the host government in the form
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of favourable financing, interest rate holidays, and help with local regulations in return for generating local employment.
The disadvantages are the financial risk and exposure involved in undertaking a new venture abroad. This is compounded
when the organization fails to adequately recruit managers who are familiar with local market conditions.
We have seen that exporting provides an organization with relatively low international risks, but gives it little control over the marketing and distribution of its products. At the other extreme, a wholly owned subsidiary gives an
organization total control over its operations and the ability to appropriate all its value, but at the expense of incurring
substantial risk. The strategic choice becomes one of more control and higher risks or low risk and low control. Licensing, international franchising, joint ventures, and strategic alliances provide varying degrees of control and exposure
to international risks. When the perceived risk is high, the organization may choose to manage this by entering into a
joint venture or franchise agreement as a means of sharing the risk.
For a discussion of entry mode, visit the online resources and see the Extension Material for this
chapter.
www.oup.com/uk/henry3e/
8
8.6 Porter’s Diamond of National Advantage
Why do some nations achieve competitive advantage in some industries while other countries achieve a similar
advantage in other industries? Michael Porter argues that a nation’s competitiveness derives from the capacity of its
industry to innovate and upgrade.20 This ability to innovate results from firms having to compete with strong domestic
rivals, aggressive suppliers, and demanding local customers. A country’s culture, national values, institutions, and
economic structures all contribute to its competitive success. In this respect, a nation’s competitive advantage results
from a localized process. As Porter states: ‘nations succeed in particular industries because their home environment is
the most forward looking, dynamic, and challenging’.21 In effect, organizations that thrive in this sort of competitive
environment are better placed to compete abroad.
Organizations that achieve competitive advantage in international markets do this through innovation. Innovation in its broadest sense refers to both new technology and new ways of doing things. It may often involve small
changes that build up over time rather than a major technological leap. It does not have to represent new ideas,
but can come about by pursuing established ideas more rigorously. Innovation does, however, involve investments
in skills and knowledge. Sustainable competitive advantage in international markets requires an organization to
engage in continuous improvements in its product offering. As competitors will eventually imitate any success,
the key to sustainable competitive advantage is an ability to upgrade or continually increase the sophistication of
product offerings.
Innovation is predicated on an ability to embrace change. However, as Danny Miller points out in The Icarus Paradox,
successful organizations have difficulty in seeing the need for change, let alone instituting change.22 When an organization is content to sit back and enjoy its current success, a change in its environment or a competitor will eventually
overtake them. The British retailer Marks & Spencer, once the doyen of retailing, is routinely criticized for its poor customer offerings as it yields revenue and market share to fashion-savvy competitors.
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8.6.1 The Diamond of National Advantage
Porter suggests organizations are capable of consistent innovation because of four attributes that exist in their home
market, which he refers to as the diamond of national advantage.23 These are (1) factor conditions; (2) demand conditions; (3) related and supporting industries; and (4) firm strategy, structure, and rivalry. Each point of the diamond contributes towards global success.
1. Factor conditions
Since the work of David Ricardo in the nineteenth century, it has been accepted that a country will tend to export
goods which make the best use of the factors of production that it has in relative abundance. In other words, it
will exploit its comparative advantage.24 These factors of production include land, labour, and capital. For Porter,
factor conditions refer to a country’s use of its factors of production that enable it to compete in an industry,
such as a skilled labour or a technological capability. In the modern economy, a country actively creates its most
important factors of production, such as a skilled labour force for its industries. Therefore, a nation’s natural stock
of factors is far less important as a determinant of international competitive advantage than it was in the past.
Natural factors of production such as labour or local resources, however abundant, are insufficient to provide for
competitive advantage. What are required are factors of production that are specialized to an industry’s needs.
8
Today, much comparative advantage derives from human effort rather than natural conditions. Such factors
will involve continuous investment to upgrade. For example, the concentration of computer companies around
Silicon Valley resulted from Xerox’s Palo Alto Research Centre, the proximity of Stanford University, and the work
of two men, Hewlett and Packard. These dynamic factors could have occurred anywhere.25 Factors such as these
that are developed within a country are scarce and difficult for competitors to imitate. Therefore, nations are successful in industries where they are especially good at factor creation (see Figure 8.4).
Determinants of National Competitive Advantage
Firm Strategy,
Structure,
and Rivalry
Factor
Conditions
Demand
Conditions
Related and
Supporting
Industries
Figure 8.4 Determinants of national competitive advantage. Source: M. E. Porter, The Competitive Advantage of Nations, Harvard Business School Publishing
Corporation, 2001. Copyright © 2001 by the Harvard Business School Publishing Corporation. Reprinted by permission of Harvard Business Review. All rights
reserved.
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PART THREE Strategy Formulation
2. Demand conditions
Demand conditions that exist in the home country can have a positive impact on its industry and, therefore,
on an organization’s ability to compete abroad. This is particularly the case where consumers are both highly
sophisticated and demanding. These consumers will be continuously pushing companies to innovate, and to
improve and upgrade their products. One benefit of this is that the constant pressure to innovate and upgrade
may provide an insight into future global trends that the organization will be in a better position to exploit. It
is in meeting the challenge of this robust consumer demand that organizations gain advantages over foreign
competitors which contributes to their success abroad. For example, Japanese companies developed a small,
quiet, air-conditioning unit utilizing energy-efficient rotary compressors. This was to benefit Japanese consumers
whose accommodation is small and tightly packed and who endure hot summers and high electrical costs.
8
3. Related and supporting industries
A third determinant of national advantage is the existence of related and supporting industries. For example,
domestic suppliers that are capable of competing in international markets will be able to provide firms with the
most cost-effective inputs. Firms that are located in close proximity to their suppliers can influence their technical
efforts and thus increase their level of innovations. Close working relationships between related and supporting
industries can produce mutually beneficial innovations. For example, a cluster of Italian footwear firms enables
shoe producers to communicate readily with their leather suppliers and learn about new textures and colours
that will help shape new styles. The suppliers benefit by receiving useful information about fashion trends that
allows them to plan more effectively. This relationship benefits from proximity, but requires a conscious effort on
the part of both parties if it is to be effective.
4. Firm strategy, structure, and rivalry
The use of different management structures in different countries tends to reflect the dynamics of their particular
industries. For instance, German management structures work well in technical industries, such as optics, which
require precision manufacturing. This calls for a tightly disciplined management structure. The existence of
strong domestic competitors is the most important factor for the creation of competitive advantage and international success. Domestic rivalry creates pressures for organizations to innovate, reduce costs, improve product
quality, and design new products. It forces companies to continually update the sources of their competitive
advantage. Intense domestic rivalry is a proving ground for domestic companies that acquire the necessary
capabilities to compete successfully abroad. It is this rivalry that causes firms to seek out new markets abroad,
confident that they have already been forged in the furnace of intense domestic competition.
In addition to these four country-specific determinants, there are also two external variables: (1) the role of chance; and
(2) the role of government.
1. The role of chance
This occurs as a result of unforeseen developments such as new inventions, political interventions by foreign
governments, wars, major instabilities in financial markets, discontinuities in input costs such as the price of oil,
and technological breakthroughs. These disruptions or tipping points were addressed in Chapter 2, when we
evaluated the macro-environment.
2. The role of government
Governments can influence all four aspects of the diamond through policies on subsidies, education and training,
regulation of capital markets, establishment of local product standards, the purchase of goods and services, tax
laws, and the regulation of competition.
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8.6.2 Criticisms of Porter’s Diamond
The main contention of Porter’s diamond framework is that an organization builds on its home base to achieve international competitiveness. Competitive advantage for the organization depends upon four broad attributes which
determine a nation’s international competitiveness. An effective organization is able to leverage its resources, capabilities, and experience acquired through competing in a rigorous home country to compete successfully abroad.
Alan Rugman and Joseph D’Cruz agree that the single diamond framework works well for multinational enterprises
based in the US, Japan, and the European Union (EU); the regional grouping referred to as the triad.26 However, they
argue that it is less effective when determining successful global competition in smaller open economies such as Canada and New Zealand.27 In fact, they state that in order to help improve the international competitiveness of Canada,
Porter’s framework needs to be substantially revised.
Rugman and Alain Verbeke also take issue with Porter’s distinction between a country’s home base, which provides
its firms with their source of competitive advantage, and other countries, which Porter argues can be selectively
‘tapped into’, but are much less important for competitive advantage than their home country.28 As Rugman and
Verbeke state:
According to Rugman, if we look at Canada, the implication of this for Canadian-owned multinational enterprises is
that their managers should treat the US diamond as their home market.30 This is because their competitive advantages
derive from attributes that exist in the US diamond rather than the Canadian diamond. In effect, Canada and other
smaller countries are simply too small to offer a basis for international competitive advantage on their own. Therefore,
greater opportunities exist for small economies that treat a larger foreign diamond as their home diamond. To capture
this, Rugman and D’Cruz suggest a double diamond framework. This allows managers of a Canadian multinational, for
example, to address the determinants of competitiveness in Canada as well as in the US when formulating their strategies.31 Richard Hodgetts points out that the multinational enterprise Nestlé achieves around ninety-five per cent of its
sales outside Switzerland.
Thus the Swiss diamond of competitive advantage is less relevant than that of foreign countries in shaping the
contribution of Nestlé to the home economy. This is not only true for Switzerland but for 95 per cent of the world’s
nations.32
When we look at smaller economies their home diamond may be important, but it is the larger diamonds of major
trading partners that are of paramount importance. Therefore, any assessment of competitive advantage must take
account of the relationship between the organization and its home and foreign diamond. As Hodgetts reminds us:
different diamonds need to be constructed and analysed for different countries, and these diamonds often require
integration and linkage with the diamonds of other economically stronger countries thus creating a double
diamond paradigm.33
8
this viewpoint does not adequately address the complexities of real world global strategic management . . . small
nations such as Canada and New Zealand . . . may come to rely on a particular large host nation . . . in such a way
that the distinction between the home base and host nations as sources of global competitive advantage may
become blurred.29
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8.7 The Myths of Global Strategy
Subramanian Rangan argues34 that there are seven common myths about companies considering a global strategy.35
1. Any company with money can go global.
The reality is that companies that succeed abroad possess valuable intangible assets that help them beat
competitors in their own home market. This can include a superior value proposition such as that developed by
the Swedish furniture retailer IKEA, and a well-known brand name, e.g. Coca-Cola. For example, if an organization’s exports are growing, this is evidence that it can offer better value than local competitors. This explains why
companies often export before seeking to commit assets aboard.
2. Internationalization in services is different.
Service companies are no different from product companies. A service company can only internationalize successfully if it also possesses valuable intangible assets that can be replicated abroad.
3. Distance and national borders don’t matter anymore.
An argument often put forward is that national cultures are converging, and distance is less important because
of developments in communication technology. The reality is that transport costs may be small, but they are
still positive and increase with distance. Moreover, a country’s culture shapes its institutions and its values. For
example, US companies export to Canada first because of the common language. To be successful requires an
organization to be local and global. For example, HSBC refers to itself as ‘the world’s local bank’ and promotes its
knowledge of local differences.
8
4. Developing countries are where the action is.
There is a belief that large markets are in developing countries like China, India, and Brazil. However, despite the
economic convergence of China, it is the Western economies that currently dominate world trade. The implication is that any organization seeking to go global cannot ignore Western economies.
5. Manufacture where labour costs are cheapest.
Rangan argues, ‘the only sounds that low wages should stir are loud yawns’. This is because, although important,
labour costs are only part of the total delivered cost. An organization may find that low-wage economies impose
tariffs and duties that increase the manufacturing cost. Furthermore, low wages may be associated with low
productivity that actually increases unit costs.
6. Globalization is here to stay.
The drivers of globalization are technological changes and economic convergence between nations. As countries
experience similar per capita incomes, so their consumer tastes begin to converge. However, if we were to see a
re-emergence of sustained unemployment that has characterized market economies in the past, this might force
governments to take unilateral actions that reverse the trend towards globalization. The argument here is that
corporations may have to accept a more socially active role if they require globalization to continue. Therefore,
organizations need to ‘explore issues such as unemployment, employee retraining and equality of opportunity . . . if
business does not become more sensitive to this possibility . . . expect to see governments reasserting themselves’.36
7. Governments don’t matter anymore.
Where organizations are believed to be pursuing their own self-interest, individuals will seek redress through
their government. A global economy requires rules and these rules are set by governments. The implication for
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multinational corporations is that they need to work with governments to ensure an acceptable balance between
the needs of companies and the needs of local people.
In discussing globalization and its drivers we have assumed, at least implicitly, that globalized companies exist.
In fact, the idea of a globalized company may represent more wishful thinking than a state of reality.
Rugman states that the largest 500 multinational enterprises (MNEs) account for around ninety per cent of
foreign direct investment and about fifty per cent of world trade.37 These impressive figures reveal an even more
interesting fact. Rugman and Verbeke argue that most of these firms are not global companies, if ‘global’ means
that they operate across innumerable foreign markets.38 The evidence suggests there are few global firms with
a global strategy, if by global we are referring to the ability to sell the same products and/or services around the
world. They are in fact ‘regional multinationals’, as the vast majority of their sales are in the home leg of their triad,
which comprises North America, the EU, and Asia. It would appear the world of international business is in fact a
regional one, not a global one.39
Thus, a US multinational enterprise would have the majority of its sales within the North American triad, a
French multinational’s sales would be predominantly in their home region, that is, the EU, and so forth. Therefore,
what some refer to as globalization may more accurately be defined as regionalization.40
In common with Bartlett and Ghoshal,41 the former chairman and CEO of IBM, Samuel Palmisano, asserts that the
traditional multinational corporation is evolving into what he calls a globally integrated enterprise.42 The goal of this
enterprise is the integration of products and value delivery worldwide. The focus of these corporations is how to make
things, rather than what to make, and how to deliver services, rather than which services to deliver. The backdrop to
these changes is the continuing economic liberalization and information technology that has standardized technologies worldwide. For example, we see financial institutions and software companies building R&D and service centres
in India to support employees, customers, and production worldwide. US radiologists send X-rays to Australia for interpretation. As organizations share business and technology standards, so integration into global production systems
is facilitated.
The increase in outsourcing encourages organizations to see themselves in terms of components or activities. The
globally integrated enterprise integrates value-chain activities such as procurement, research, and sales on a global
basis in order to produce its goods and services for consumers. The choice for organizations is where they want the
work for these activities to be done and whether they want them carried out in-house or outsourced. This should be
seen as not merely a matter of outsourcing non-core activities, but is ‘about actively managing different operations,
expertise, and capabilities so as to open the enterprise up . . . allowing it to connect more intimately with partners,
suppliers, and customers’.43
The globally integrated enterprise brings opportunities and a number of challenges. The opportunities include
increases in living standards in developed and developing countries. Developing countries experience increased
employment and prosperity as their workers become more integrated into global production systems. This is also
helped by structural changes that allow small and medium-sized organizations in developing countries to participate
in the global economy. However, there are difficult challenges. The globally integrated enterprise requires a supply of
high-value skills that requires nations to invest in education and training.
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PART THREE Strategy Formulation
A key challenge in the global economy is how to prevent piracy of intellectual property rights without sacrificing collaboration. A possible solution is to shift the emphasis from protecting intellectual property, which limits its use, to
maximizing intellectual capital based on shared ownership. How do firms maintain trust when their business models
are dispersed globally? This will require shared values that transcend national borders. Finally, some of the changes
that global corporate integration brings will require that capital markets and investors adjust their habits from shortterm rewards to longer-term growth. Given the investment nature of Anglo-American economies, this is quite a challenge. Palmisano concludes:
The shift from MNCs to globally integrated enterprises provides an opportunity to advance both
business growth and societal progress. But it raises issues that are too big . . . for business alone or
government alone to solve.44
If we accept the model of the globally integrated enterprise as more optimal than the multinational corporation, there
is a need to ensure that it evolves in a manner which benefits all members of society around the world. This issue is
addressed in greater detail in Chapter 11 when we assess the role and impact of corporate governance. A wider issue
is some evidence suggests that global firms, far from dominating the global landscape, are in retreat as multinationals’
cross-border investment falls (see Strategy in Focus 8.2).
8
STRATEGY IN FOCUS 8.2 Globalization in Retreat
Between 1990 and 2005 Kentucky Fried Chicken (KFC) and McDonald’s combined foreign sales soared by 400
per cent. McDonald’s and KFC embodied an idea that would become incredibly powerful: global firms, run by
global managers and owned by global shareholders, should sell global products to global customers. For a long
time their planet-straddling model was as hot, crisp, and moreish as their fries. Today both companies have
gone soggy. Their shares have lagged behind the American stock market over the past half-decade. Yum, which
owns KFC, saw its foreign profits peak in 2012; they have fallen by twenty per cent since. Those of McDonald’s
are down by twenty-nine per cent since 2013. In 2016, Yum threw in the towel in China and spun off its business
there. In 2017, McDonald’s sold a majority stake in its Chinese operation to a state-owned firm. The world is
losing its taste for global businesses.
Their detractors and their champions both think of multinational firms—for the purposes of this article, firms
that make over thirty per cent of their sales outside their home region—as the apex predators of the global
economy. They shape the ecosystems in which others seek their living. They direct the flows of goods, services,
and capital that brought globalization to life. Though multinationals account for only two per cent of the
world’s jobs, they own or orchestrate the supply chains that account for over fifty per cent of world trade; they
make up forty per cent of the value of the West’s stock markets; and they own most of the world’s intellectual
property. Although the idea of being at the top of the food chain makes these companies sound ruthless and
all-conquering, rickety and overextended are often more fitting adjectives. And like jackals, politicians want
to grab more of the spoils that multinational firms have come to control, including eighty million jobs on their
payrolls and their profits of about $1trillion. As multinational firms come to make ever more of their money from
technology services they become yet more vulnerable to a backlash. The predators are increasingly coming to
look like prey.
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It all looked very different twenty-five years ago. With the Soviet Union collapsing and China opening up,
a sense of destiny gripped Western firms; the ‘end of history’ announced by Francis Fukuyama, a scholar, in
which all countries would converge towards democracy and capitalism seemed both a historical turning-point
and a huge opportunity. There were already many multinationals, some long established. Shell, Coca-Cola,
and Unilever had histories spanning the twentieth century. But they had been run, for the most part, as loose
federations of national businesses. The new multinationals sought to be truly global. Companies became
obsessed with internationalizing their customers, production, capital, and management. Academics draw
distinctions between going global ‘vertically’—relocating production and the sourcing of raw materials—and
‘horizontally’—selling into new markets. But in practice many firms went global every which way at once,
enthusiastically buying rivals, courting customers, and opening factories wherever the opportunity arose.
Though the trend started in the rich world, it soon caught on among large companies in developing economies,
too. And it was huge: eighty-five per cent of the global stock of multinational investment was created after
1990, after adjusting for inflation.
By 2006 Sam Palmisano, the boss of IBM, was arguing that the ‘globally integrated enterprise’ would
transcend all borders as it sought ‘the integration of production and value delivery worldwide’. From the Seattle
demonstrations of 1999 onwards, anti-globalization activists had been saying much the same, while drawing
less solace from the prospect. The only business star to resist the orthodoxy was billionaire, Warren Buffett; he
sought out monopolies at home instead. Such a spree could not last forever; an increasing body of evidence
suggests that it has now ended. In 2016 multinationals’ cross-border investment probably fell by between ten
and fifteen per cent. Impressive as the share of trade accounted for by cross-border supply chains is, it has
stagnated since 2007. The proportion of sales that Western firms make outside their home region has shrunk.
Multinationals’ profits are falling and the flow of new multinational investment has been declining relative to
GDP. The global firm is in retreat.
To understand why this is, consider the three parties that made the boom possible: investors; the ‘headquarters
countries’ in which global firms are domiciled; and the ‘host countries’ that received multinational investment.
For their different reasons, each thought that multinational firms would provide superior financial or economic
performance.
Investors saw a huge potential for economies of scale. As China, India, and the Soviet Union opened up,
and as Europe liberalized itself into a single market, firms could sell the same product to more people. And
as the federation model was replaced by global integration, firms would be able to fine-tune the mix of
inputs they got from around the world—a geographic arbitrage that would improve efficiency. From the
rich world they could get management, capital, brands, and technology. From the emerging world they
could get cheap workers and raw materials, as well as lighter rules on pollution. These advantages led
investors to think global firms would grow faster and make higher profits. That was true for a . But it is not
true today. For the three countries which have, historically, hosted the most and biggest multinationals,
the US, the UK, and the Netherlands, return on equity (ROE) on foreign investment has shrunk to between
four and eight per cent. The trend is similar across the Organization for Economic Cooperation and
Development (OECD).
What about the second constituency for multinationals, the ‘headquarters countries’? In the 1990s and 2000s
they wanted their national champions to go global in order to become bigger and brainier. The mood changed
after the financial crisis. Multinational firms started to be seen as agents of inequality. They created jobs abroad,
but not at home. Between 2009 and 2013, only five per cent, or 400,000, of the net jobs created in the US
were created by multinational firms domiciled there. The profits from their hoard of intellectual property were
8
The Other End of the End of History
230
PART THREE Strategy Formulation
pocketed by a wealthy shareholder elite. Takeovers of Western firms now often come with strings attached
by governments to safeguard local jobs and plants. A typical multinational has over 500 legal entities, some
based in tax havens. Using US figures, it pays a tax rate of about ten per cent on its foreign profits. The European
Union (EU) is trying to raise that figure. It has cracked down on Luxembourg, which offered generous deals to
multinationals that parked profits there. US policians also wants Apple to shift more of its supply chain home. If
these trends continue, global firms’ tax and wage bills will rise, squeezing profits further.
Of all those involved in the spread of global businesses, the ‘host countries’ that receive investment by
multinationals remain the most enthusiastic. China, where by 2010 thirty per cent of industrial output and
fifty per cent of exports were produced by the subsidiaries or joint-ventures of multinational firms, is still
attractive. India has a campaign called ‘make in India’ to attract multinational supply chains. But there are
gathering clouds. China has been turning the screws on foreign firms in a push for ‘indigenous innovation’.
Bosses say that more products have to be sourced locally, and intellectual property often ends up handed
over to local partners. Many fear that China’s approach will be mimicked around the developing world,
forcing multinational firms to invest more locally and create more jobs—a mirror image of the pressures
placed on them at home.
Today multinationals need to rethink their competitive advantage. Roughly fifty per cent of the stock of
foreign direct investment makes an ROE of less than ten per cent. Ford and General Motors make eighty per cent
or more of their profits in North America, suggesting that their foreign returns are abysmal. Retailers such as
the UK’s Tesco and France’s Casino have abandoned many of their foreign adventures. LafargeHolcim, a cement
maker, plans to sell, or has sold, businesses in India, South Korea, and Vietnam. P&G’s foreign sales have dropped
by almost one-third since 2012, as it has closed or sold weak businesses. Politicians will increasingly insist that
companies buying foreign firms promise to preserve their national character, including jobs, R&D activity, and
tax payments. SoftBank, a Japanese firm that bought ARM, a British chip company, in 2016, agreed to such
commitments. The new, prudent age of the multinational will have costs. The result will be a more fragmented
and parochial kind of capitalism, and quite possibly a less efficient one—but also, perhaps, one with wider
public support. And the infatuation with global companies will come to be seen as a passing episode in business
history, rather than its end.
8
Source: ‘The retreat of the global company’, The Economist, 28 January 2017. Reproduced with permission.
Summary
We started this chapter with an evaluation of the views of Theodore Levitt on globalization. While globalization
may indeed be increasing, the assertion that consumer preferences are irrevocably homogenized is considered by
some to ignore the realities of important national differences. Douglas and Wind argue that while there exist global
segments with similar needs, this is not a universal trend. This debate between globalization and localization is of
crucial important as it goes to the heart of the type of international strategy an organization adopts. We saw that
the motives for companies to expand internationally can be evaluated by looking at organizational and environmental factors. The organizational factors occur within the company, while the environmental factors are outside
the company’s control.
A global framework for guiding managers is provided by Ghoshal who outlines three objectives for multinational
corporations and the sources of competitive advantage open to them. We assessed four basic types of international
CHAPTER 8 International Strategy
231
strategy that are a response to the globalization–localization debate: multidomestic, global, international, and transnational. The transnational organization, developed by Bartlett and Ghoshal, is a recognition that a search for a match
between an organization’s capabilities and a single set of environment forces no longer holds.
In selecting an appropriate entry mode strategy, organizations need to answer two questions: what levels of resource
commitment are they prepared to make, and what level of control over their international operations do they require?
The answer to these questions will be determined by an organization’s perception of international risk. We saw that,
according to Porter, firms are capable of consistent innovation because of four attributes that exist in their home
market, which he refers to as the diamond of national advantage. Each point of the diamond contributes to global
success. There are criticisms of Porter’s diamond and some, such as Rugman and D’Cruz, argue that smaller nations’
competitive advantage may actually derive from attributes that exist in their larger foreign diamond. To take account
of this, Rugman suggests using a double diamond framework. Lastly, we addressed some of the myths of globalization, whether a global firm even exists, and a globally integrated enterprise.
8
CASE EXAMPLE Inditex’s International Reach
Zara is one of Inditex’s biggest brands. Source: © Vytautas Kielaitis/Shutterstock
Amancio Ortega is the biggest shareholder in Inditex, a Spanish company he started more than forty years ago,
which owns Zara and other brands. The billionaire owns almost sixty per cent of Inditex through two companies, Pontegadea Inversiones and Partler. He is known to be fiercely private, foregoing interviews and avoiding
being photographed. He is, however, familiar to residents of La Coruña; a city in northern Spain, which is close
to where Inditex is headquartered.
Ortega opened the first Zara store in La Coruña in 1975. He was a local clothing manufacturer who had
worked his way up from being a delivery boy at a shirt maker. The founder of Inditex tends to compare selling
fashion to selling fish. A freshly cut garment in the latest colour, like fresh fish, tends to sell quickly at a high price.
However, fish caught yesterday must be heavily discounted and may not even sell. Ortega is over eighty years
old, the world’s fourth richest person in the world and the richest European. His personal fortune is estimated at
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$71.5 billion (£58 billion), according to the Forbes World’s Billionaires rankings. Only Microsoft’s Bill Gates, investor Warren Buffett, and Amazon boss Jeff Bezos are wealthier.
Inditex is the world’s largest fashion retailer, followed by H&M Hennes and Mauritz of Sweden. Through Inditex’s premier brand, Zara, its clothing has dominated Europe and Asia. It operates across ninety-three countries
and has a total number of almost 7,300 stores; of which, 2,200 are Zara stores. It employs 162,450 people. It has
invested heavily in its warehouses in its home country, to allow clothing to be packed and dispatched at a faster
rate. Inditex continues to grow in all its markets, including the UK—where some rivals, such as Next and Marks
& Spencer, have found competing difficult. It achieved record financial results for 2016 with net profit of €3.2
billion, on total sales of more than €23 billion. As a result, Ortega will receive €1.26 billion (£1.1 billion) from
Inditex, as dividend payments. The group also announced plans to give its employees more than €535 million in
2017, over and above their existing salaries.
Inditex’s current chairman and chief executive is Pablo Isla. Isla took over as chairman from Ortega in 2011,
and is widely credited with the introduction of an online presence for Zara. Under Isla, Zara Home has launched
its first perfume for men and women, as well as its first washing powder, fabric conditioner, and ironing range.
Constant renovations to its worldwide stores remains a key to success; in the UK, Inditex refurbished its flagship
store on Oxford Street in London.
8
Inditex’s Business Model
Most fashion companies have their clothes manufactured in China. This provides low cost manufacturing,
but at the expense of flexibility. Managing a distant supply chain creates an inherent problem. By the time
finished clothes are on route from your supplier, the prevailing fashion may have changed. The clothes you
place in your retail store can end up looking decidedly out of fashion. Most clothing retailers are forced to
continue with plans they developed more than six months in advance. Their clothes are usually made and
sent out to stores via a centrally controlled system. This permits only slight local changes and most stores
receive similar stock.
At Inditex, every store receives a tailored assortment, right down to the number of T-shirts, delivered twice
a week. Just over half the stock will be designed and manufactured less than a month before it hits the store.
Prices can vary considerably between countries. Shoppers in Spain, Portugal, and Greece can buy the clothes as
much as thirty per cent cheaper than elsewhere in Europe or overseas markets such as China or the US. As one
director at Inditex put it, ‘The company is global, but we shape everything in a very exclusive way to individualise
it and shape the store to the customer’s needs.’
Part of Inditex’s business model is a reliance on communication and collaboration. The store’s stock is
developed in partnership between designers, country managers based at the brands’ HQs, and the local
store. This level of collaboration allows everyone to feedback ideas about what customers want and don’t
want. The business is configured in a way that allows decisions to be made from the bottom to the top, not
just in the stores, but throughout the supply chain. Just over half of Inditex’s product is only ever produced
in relatively small amounts; even if something is incredibly successful, it will never be reproduced exactly
again. Designers find versatile fabrics that can easily work as well in a skirt as a jacket to help facilitate Inditex’s flexible approach.
Unlike other clothing manufacturers, Inditex does not advertise. Its avoidance of advertising is partly
driven by its manufacturing model, which relies on constantly changing its garments. This precludes placing advertisements in magazines or billboards which require a lead time of weeks or month. However, its
website can be updated every day, reflecting real-time changes. Instead, it relies upon smart locations and
regularly updating the look of its stores. It is one of the main areas of capital expenditure for Inditex, with
300 to 400 stores a year to renovate. While competing clothing retailers struggled, Inditex reported a ten
per cent rise in sales in 2016, after it had invested €1.4 billion in its warehouses, technology, new stores,
and online expansion.
As part of the decision-making process for the Zara brand managers, for each country monitor computer screens
at headquarters filled with sales data and talk to store managers or regional directors by phone. Managers are
helped by computer algorithms, developed in partnership with Massachusetts Institute of Technology. The use of
computer technology helps Zara to get the right mix of sizes for stores. Although managers are guided by these
automatic suggestions, they have autonomy to adjust everything manually, according to local feedback and
market knowledge.
Over ninety-five per cent of Zara’s collections are sold internationally. That said, there are still regional differences. For example, Zara’s clothes in Germany tend to be a bit sporty; in Russia, they might wear a pencil
skirt with high heels, but in the UK it would be worn with a brogue. At the same time, as different stores
around the world are selling similar fashions, Zara stores around the corner from each other might be selling different items of clothing. It’s all dictated by their shoppers. Staff at head office can make adjustments
for products in as little as three weeks in advance, using production in or close to Europe; primarily Turkey,
Spain, and Portugal.
At headquarters in Arteixo, there are eleven factories owned by Inditex producing goods for the Zara brand.
Inditex’s capability lies in skilled jobs, such as cutting out garment pieces, clothing design, and logistics; all of
which it keeps in-house. It owns just two or three per cent of its manufacturing capacity. The sewing of fabric
pieces is undertaken by more than 100 nearby partner factories that make pieces sent from the Inditex-owned
factories into finished clothes.
Many have referred to this as ‘fast fashion’. Executives at Inditex insists: ‘It’s not fast, it’s more accurate. What’s
fast is the logistics, and the moment of creation must be close to what customers are saying. To be quick is easy.
But that is not our model. Everything we do is trying to think inside the skin of the customer. It’s more expensive,
but you get more loyalty from the customers and more flexibility, more accuracy.’
Another of Inditex’s capabilities is its distribution system. In Arteixo, all Inditex’s factories are linked to its
distribution centre by tunnels and a 200-km network of ceiling rails on which 50,000 garments a week from each
factory flow around on hangers. Basic items of clothing made in Asia are gathered in Spain, before being sorted
for individual stores. The model may be under some pressure since Asia overtook Spain as the biggest source of
sales. Routing all its products to a small town in Spain to be sorted, may require changing this to a small town in
China. Inditex’s Business model appears quite straightforward; which begs the question—why has it not been
successfully copied?
Questions
1. What type of international strategy would you say Inditex is following? Justify your answer.
2. Why is it that no other fashion retailer can match Zara’s performance?
Sources: Angela Monaghan,‘Zara founder to receive £1.1bn payout after record sales’, The Guardian, 15 March 2017;‘Zara, Spain’s most successful brand, is trying
to go global’, The Economist, 24 March 2012; Sarah Butler, ‘Inditex: Spain’s fashion powerhouse you’ve probably never heard of’, The Guardian, 15 December
2013; https://www.inditex.com/brands/zara
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PART THREE Strategy Formulation
Review Questions
1. Examine the arguments for and against the increasing homogenization of consumer tastes.
2. Evaluate Porter’s diamond of national advantage with reference to smaller trading nations such as New
Zealand or Canada.
Discussion Question
There is no such thing as a global company. Discuss.
Research Topic
Identify a well-known firm that is often referred to as a global company. Examine whether the evidence supports
this or whether it is, in fact, a regional multinational.
Recommended Reading
For opposing perspectives on globalization see:
●
8
●
T. Levitt, ‘The globalization of markets’, Harvard Business Review, vol. 61, no. 3 (1983), pp. 92–102.
S. Douglas and Y. Wind, ‘The myth of globalization’, Columbia Journal of World Business, vol. 22, no. 4
(1987), pp. 19–29.
For a discussion of a new organizational form, the transnational corporation, which is needed to deal with a
dynamic business world, see:
●
C. A. Bartlett and S. Ghoshal, Managing Across Borders: The Transnational Solution, Harvard Business
School Press, 1989.
For an understanding of what it means to be a global company, see:
●
A. M. Rugman, The Regional Multinationals, Cambridge University Press, 2005.
www.oup.com/uk/henry3e/
Visit the online resources that accompany this book for activities and more information on international strategy.
References and Notes
1
T. Levitt, ‘The globalization of markets’, Harvard Business Review, vol. 61, no. 3 (1983), pp. 92–102.
2
S. Douglas and Y. Wind, ‘The myth of globalization’, Columbia Journal of World Business, vol. 22, no. 4 (1987),
pp. 19–29.
3
Douglas and Wind, n. 2.
4
P. Ghemawat, ‘Regional strategies for global leadership’, Harvard Business Review, vol. 83, no. 12 (2005), pp.
98–108.
5
G. Hofstede, Cultures and Organizations: Software of the Mind, McGraw-Hill, 1991.
6
Hofstede, n. 5.
7
S. Ghoshal, ‘Global strategy: an organizing framework’, Strategic Management Journal, vol. 8, no. 5 (1987),
pp. 425–40.
8
Ghoshal, n. 7.
9
See Porter’s generic strategies in Chapter 7 for an explanation of the firm as a low cost producer and
differentiator.
10
Ghoshal, n. 7, p. 427.
11
‘Wal-Mart quits Germany but insists ASDA is safe’, The Daily Telegraph, 29 July 2006; ‘Aldi to invest extra
$1.6bn in US expansion’, Financial Times, 9 February 2017.
12
The discussion of transnational strategy draws upon the work of C. Bartlett and S. Ghoshal,
Managing across Borders: The Transnational Solution, Harvard Business School Press, 1989.
13
Bartlett and Ghoshal, n. 12, p. 21.
14
Bartlett and Ghoshal, n. 12, p. 59.
15
Bartlett and Ghoshal, n. 12, p. 61.
16
K. D. Brouthers, ‘The influence of international risk on entry-mode strategy in the computer software
industry’, Management International Review, vol. 35 no. 1 (1995), pp. 7–28.
17
K. D. Miller, ‘A framework for integrated risk management in international business’, Journal of
International Business Studies, vol. 23, no. 2 (1992), pp. 311–31.
18
For a discussion of different entry modes, see J. G. Frynas and K. Mellahi, Global Strategic Management’,
Oxford University Press, 2015.
19
‘The lessons from Danone HSBC’s troubled partnerships in China’, The Economist, 19 April 2007.
20
M. E. Porter, The Competitive Advantage of Nations, Free Press, 1990, chapter 3.
21
M. E. Porter, ‘The competitive advantage of nations’, Harvard Business Review, vol. 68, no. 2 (1990), p. 74.
22
D. Miller, The Icarus Paradox: How Excellent Companies Can Bring about Their Own Downfall, Harper
Business, 1990.
23
Porter, n. 21.
24
David Ricardo’s work on comparative advantage is contained in On the Principles of Political Economy and
Taxation, which was published in 1817.
25
A. S. Blinder, ‘Offshoring: the next industrial revolution’, Foreign Affairs, vol. 85, no. 2 (2006), pp. 113–28.
26
A. Rugman and J. R. D’Cruz, ‘The ‘double diamond’ model of international competitiveness: the Canadian
experience’, Management International Review, vol. 33, no. 2 (1993), pp. 17–39.
27
For a discussion of the relevance of Porter’s diamond for New Zealand, see W. R. Cartwright, ‘Multiple
linked “diamonds” and the international competitiveness of export-dependent industries: the New
Zealand experience’, Management International Review, vol. 33, no. 2 (1993), pp. 55–70.
235
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8
236
PART THREE Strategy Formulation
28
A. Rugman and A. Verbeke, ‘Foreign subsidiaries and multinational strategic management: an extension
and correction of Porter’s single diamond framework. Management International Review, 33, no. 2 (1993),
pp. 71–84.
29
Rugman and Verbeke, n. 28, p. 76.
30
A. Rugman, ‘Porter takes the wrong turn’, Business Quarterly, vol. 56, no. 3 (1992), pp. 59–64.
31
A. Rugman and J. R. D’Cruz, Fast Forward: Improving Canada’s International Competitiveness,
Kodak Canada, 1991.
32
R. M. Hodgetts, ‘Porter’s diamond framework in a Mexican context’, Management International Review,
vol. 33, no. 2 (1993), p. 45.
33
Hodgetts, n. 32, p. 46.
34
S. Rangan, ‘The seven myths regarding global strategy’, in Mastering Strategy, Prentice Hall, 2000.
35
S. Rangan and R. Z. Lawrence, A Prism on Globalization, Brookings Institute, Washington, DC, 1999.
36
Rangan, n. 34, p. 123.
37
A. M. Rugman, The End of Globalization, Random House, 2000.
38
A. Rugman and A. Verbeke, ‘A perspective on regional and global strategies of multinational enterprise’,
Journal of International Business Studies, vol. 35, no. 1 (2004), pp. 3–18.
39
A. Rugman, The Regional Multinationals, Cambridge University Press, 2005.
40
Ghemawat, n. 4.
41
Bartlett and Ghoshal, n. 12, p. 21.
42
S. J. Palmisano, ‘The globally integrated enterprise’, Foreign Affairs, vol. 85, no. 3 (2006), pp. 127–36.
43
Palmisano, n. 42, p. 131.
44
Palmisano, n. 42, p. 136.
PART FOUR
STRATEGY
IMPLEMENTATION
9 Organizational Structures and Strategic Change
239
10 Strategic Leadership
271
11 Corporate Governance
301
CHAPTER 9
ORGANIZATIONAL STRUCTURES AND
STRATEGIC CHANGE
9.1 Organizational
Structures
9.2 Organizational
Processes
9.3 Strategic
Control Systems
9.4 Strategic Change
Extension Material
Strategic control
systems
Extension Material
Role of BHAGs in
stimulating change
Main Reference
Goold, M. and Quinn, J.J.
(1990). The paradox of
strategic controls. Strategic
Management Journal,
11(1), 43–57.
Learning Objectives
After completing this chapter you should be able to:
●
●
●
●
●
●
Explain the trade-off between specialization and coordination
Evaluate different organizational structures
Discuss organizational processes
Evaluate strategic control systems
Assess different types of strategic change
Identify what determines a visionary organization
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PART FOUR Strategy Implementation
Introduction
In Part 3 we assessed the role that strategy formulation plays in the achievement of competitive advantage. In Part 4
we turn our attention to strategy implementation. We might restate that although a linear approach aids the student
of strategic management in getting to grips with the subject, in the fast-moving corporate world organizations are
often faced with implementing a strategy without the luxury of comprehensive analysis. That is not to say that analysis is unimportant, since organizations neglect strategic analysis at their peril. It is to recognize that decisions often
need to be made quickly, as competitors seldom wait for their rivals to undertake a complete analysis of the business
environment.
It is often said that the best formulated strategy in the world will fail if it is poorly implemented. To implement strategies effectively requires the organization to be sufficiently flexible in its organizational design. Strategies need to
be effectively communicated and properly resourced. The reason for change needs to be understood and properly
coordinated with stakeholders inside and outside the organization. In an age of collaboration, this may involve discussions with suppliers and partners. Although the leader of an organization will ultimately be responsible for a strategy’s
success or failure, their role should be to encourage and create an organizational culture that empowers managers to
respond to opportunities. In this way, each employee will be confident to try out new ideas and innovate without fear
of reprisals.
Appropriate reward mechanisms need to be in place that help to guide employee behaviour and signpost the important goals of the organization. The values of an organization will be important here in specifying what an organization
stands for. There must also be sufficient control mechanisms in place to allow the strategy to be evaluated against its
stated aims and if necessary, allow for changes.
9
Although systems, procedures, and policies may aid the implementation of a strategy, ultimately it is individuals who
implement strategy. Unless individuals and groups, within and outside the organization, accept the rationale for strategic change, any proposed implementation will be suboptimal at best. We address the role that leadership plays in
managing strategic change in Chapter 10.
In this chapter, we address the role of organizational structures, organizational processes, strategic control systems,
and strategic change. The backdrop to the chapter is the role these play in providing an organization with competitive
advantage.
9.1 Organizational Structures
Organizational structure is concerned with the division of labour into specialized tasks and coordination between
these tasks. Organizations exist because they are more efficient at undertaking economic activities than individuals are on their own. Therefore, organizations are a means by which human economic activity can be coordinated.
Henry Mintzberg argues that all organized human activity gives rise to two opposing forces: the need to divide
labour into separate tasks, and the coordination of these tasks to accomplish some goal.1 Adam Smith first discussed specialization and the division of labour centuries earlier in 1776. Smith showed that if you specialize human
activity such that individuals only undertake one or a few tasks, they then become proficient at that task.2 If each
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241
task is part of some larger activity, such as building a car, then we find that more cars can be built when each individual specializes than if an individual tried to build a car by himself. This is what made Henry Ford’s Model T automobile so successful—the division of labour along a moving conveyor belt. Yet, as Mintzberg points out, greater
specialization requires greater coordination.
The use of rules, policies, and procedures to coordinate employees will be appropriate for organizations that operate in a
relatively stable environment. This is especially the case where individuals have little autonomy and are not expected to
make complex decisions. Where individuals are part of an organization that operates in a turbulent environment and are
afforded far greater autonomy, the effort required by management to coordinate their activities will be greater. Nevertheless, these different activities must still be coordinated if the organization is to achieve economies of scale and synergy.
For Chandler, it is the formulation of a new strategy which brings forth the need for a new structure. Hence his dictum ‘structure follows strategy’ (Figure 9.1). This is not to say that structure has no impact on strategy; for example,
changes in the external environment may necessitate a change in an organization’s structure. Therefore, there will be
instances when Chandler’s dictum may not hold, but as a general rule there is substantive support for this proposition.
For example, a dynamic assessment of the contingent relationship between strategy and structure by Terry Amburgey
and Tina Dacin found that a reciprocal relationship does exist.4 In other words, strategy affects structure, but structure
also affects strategy. However, they found that strategy was a more important determinant of structure than structure
was of strategy. They conclude: ‘our research supports the existence of a hierarchical relationship between strategy
and structure’, but note that ‘a change in strategy is more likely to produce a change in structure than a change in
structure is to produce a change in strategy’.5
New strategy
is formulated.
New administrative
problems emerge.
Organizational
performance improves.
Organizational
performance declines.
A new organizational
structure is established.
Figure 9.1 Strategy and structure. Source: Adapted from Chandler, Alfred D., Strategy and Structure: Chapters in the History of the American Industrial Enterprise, MIT
Press, 1962. © 1962 Massachusetts Institute of Technology, by permission of The MIT Press.
9
There is widespread acceptance that a change in strategy, other things being equal, will warrant a change in organizational structure to implement that strategy. Alfred Chandler wrote his famous dictum that ‘structure follows strategy’.3
He studied a number of large US corporations, including General Motors and DuPont, in the early part of the twentieth
century. He found that as these organizations grew in size and complexity, so this brought about a need to change
their organizational structure. For instance, Chandler found that as DuPont increased its product lines, so the ensuing complexity was too much for its centralized functional structure. An expansion of its activities produced ‘new
administrative needs’ which required a new structure to meet these needs. In effect, the existing structure becomes
suboptimal for supporting the strategic change, which in turn necessitates a change of structure. The same was true
of General Motors. DuPont decentralized its organization to what became known as a divisional structure. Under a
divisional structure the head office retains control of overall strategic direction, but the divisional managers have
autonomy as to how the strategy will be implemented. This is discussed in detail later.
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In many respects, whether structure follows strategy or strategy follows structure may be a bit of a red herring. The real
issue may be more about organizing complementary practices that fit together in a dynamic manner. For example, an
organization introducing flexible technology will be unlikely to obtain increases in performance when it fails to change
related working practices. Therefore, to ensure a better organizational fit it becomes necessary to go beyond a discussion of strategy and structure to include processes. This idea of complementarities is discussed later in the chapter.
We can now evaluate different types of organizational structures in terms of how well they meet the trade-off between
specialization and coordination.
9.1.1 The Entrepreneurial Structure
The entrepreneurial or simple structure revolves around the founder of the firm. This is a centralized structure in which
the founder or entrepreneur takes all the major decisions. This is not unexpected, especially where the founder possesses some technical expertise or specific knowledge that is the basis for the organization’s existence. In these small
companies, staff members will often be expected to be flexible in their work roles, which may not be clearly drawn.
The vision of the entrepreneur and flexible work patterns of staff are major strengths of this type of organization. As
the organization grows, so the entrepreneur’s ability to manage each facet of the business becomes stretched. Where
the founder recognizes that his or her strength lies in formulating a strategic intent or purpose, but not necessarily in
trying to manage functions such as marketing or finance, they will recruit specialists to run these activities. Steve Jobs,
the co-founder and former CEO of Apple, ran the company during its start-up. As Apple grew in size his management
style was perceived to be a liability. He was eventually replaced, not by an individual who possessed his visionary zeal
or technical expertise, but by someone the financial markets believed could successfully manage a growing organization. In an ironic twist, Jobs was brought back to head up the computer firm. With Jobs as CEO, Apple went on to design
and manufacture spectacularly successful consumer products making it one of the most successful corporations in the
world. A legacy that successive CEOs of Apple will find hard to emulate.
9
9.1.2 The Functional Structure
A functional structure is appropriate for an organization which produces one or a few related products or services. Tasks are grouped together according to functional specialisms such as finance, marketing, and R&D. A
manager will be responsible for a department which comprises these functions. The use of a functional structure
promotes efficiency through the specialized division of labour. It allows individuals to learn from each other and
may facilitate the development of capabilities. Under a functional structure, control systems, which are used to
guide the behaviour of members of the organization, are straightforward and do not involve great complexity.
There is a high degree of centralization, with each functional manager reporting to the CEO and board of directors (Figure 9.2).
Chief Executive Officer
Production
Figure 9.2 A functional structure.
Marketing
Finance
Human Resources
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243
The functional structure has a number of disadvantages. Each functional or departmental manager may begin to focus
exclusively on their departmental goals at the expense of the organizational goals. This can lead to the development of
a departmental subculture whose values may not be fully congruent with those within the organization. As the organization grows and its range of products expands, coordination between functions becomes more difficult. This can lead
to a decline in performance which, as Chandler argued, leads to a search for a new structure. This new structure will
involve greater decentralization of decision making to improve the efficiency of coordination.
9.1.3 The Divisional Structure
As organizations grow and diversify into producing different products for different markets, a more effective and
efficient structure is required. The divisional structure comprises individual business units that include their own
functional specialisms and have direct responsibility for their own performance (Figure 9.3). This decentralization of
decision making is also necessary where the external environment is fast-moving and exhibits some degree of uncertainty. It gives managers substantial autonomy to respond to local market conditions. A divisional structure may be
organized according to product, market, or geographic areas.
The advantages of a divisional structure include the decentralized decision making which allows divisional managers
to respond effectively to the needs of their business unit. There is a more clearly defined career path for individuals
within the division rather than the limited specialisms that exist under a functional structure. This leads to higher
Chief Executive Officer
Head Office Centralized
Services, eg. Legal Services
DIVISION A
FINANCE
Function
Figure 9.3 A divisional structure.
PRODUCTION
Function
MARKETING
Function
DIVISION B
DIVISION C
as per Division A
as per Division A
HUMAN RESOURCES
Function
9
A structure based on product occurs when each product line is based in its own division, with a manager responsible for profitability within that division. The divisional manager will have autonomy to set a business-level strategy
based on his or her understanding of the product and markets. Organizations that have adopted a divisional structure
by product include DuPont, General Motors, and Procter & Gamble. A structure based on market occurs when an
organization is concerned to meet the needs of different customer groups. For example, HSBC and Barclays Bank are
organized according to the markets they serve; corporate customers, small business customers, and retail customers.
Each division has responsibility for its own profits and can see its contribution to corporate profitability. A geographic
structure occurs when the divisions are categorized according to geographic location. Breaking the organization’s
structure down into geographic locations facilitates better management decisions by allowing managers to take decisions based upon the needs and attributes of consumers within different areas.
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levels of motivation and a commitment to innovation. Under a divisional structure, individuals are more likely to be
aligned to the organization’s objectives. A divisional structure allows head office to focus its attention on corporate
strategy rather than being drawn into operational issues. In addition, the profit contribution of each division is transparent which helps the centre to make effective parenting decisions.
There are disadvantages with a divisional structure. Where the centre allocates resources to divisions according to their
profit contribution, this presupposes that each division has an equal opportunity to make the same level of profits.
Markets, products, and geographic regions will differ, and some mechanism which takes account of these differences
and allocates resources fairly needs to be devised by head office. The emphasis on, for example, quarterly profit target
may force the division to focus its attention on short-term issues rather than on key business-level strategies. The
duplication of functions across many different divisions as well as at head office can be expensive and needs to be
offset against improvements in performance. The use of divisional structures among large corporations is widespread,
with many organizations adopting variations of the divisional form. However, where organizations face greater uncertainty and more rapid change in their environment a different kind of organizational structure is required.
9.1.4 The Matrix Structure
A matrix structure is an attempt to increase organizational flexibility to meet the needs of a rapidly changing environment. It aims to simultaneously maximize the benefits from functional specialisms that occur from the division
of labour while increasing the efficiency of coordination across these functions. It involves learning new roles and
modes of behaviour. In a matrix structure, an individual reports to two managers. This will include their functional
head (for instance, the head of manufacturing) and also a project manager. Individuals are usually assigned to the
project on a temporary basis (Figure 9.4). In theory, a matrix structure should increase the speed of decision making, facilitate innovation, and enhance responsiveness to the external environment. In reality, matrix structures can
be complex and difficult to implement effectively. They violate a fundamental principle of management, which is
the unity of command.
9
Chief Executive
&
Board of Directors
Project
Manager
Marketing
Manager
Finance
Manager
Production
Manager
Project X
Marketing
Staff
Finance
Staff
Production
Staff
Project Y
Marketing
Staff
Finance
Staff
Production
Staff
Project Z
Marketing
Staff
Finance
Staff
Production
Staff
Figure 9.4 A matrix structure.
CHAPTER 9 Organizational Structures and Strategic Change
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Unless both managers have the same expectations from individuals reporting to them this can create role incompatibility and role ambiguity. Role incompatibility occurs when the different expectations of managers make it highly
unlikely that individuals can meet the expectations of both managers. Role ambiguity implies that individuals are
unclear as to what their role and responsibilities are. The need to meet the expectations of different managers
may ultimately result in role overload, where an individual experiences difficulty in managing varied expectations.
Christopher Bartlett and Sumantra Ghoshal argue that concentrating on a matrix structure to manage complex and
dynamic environments does little to change the other important elements that make up an organization.6 They
distinguish between an organization’s anatomy, its physiology, and psychology. Its anatomy refers to an organization’s structure. Its physiology includes the systems that allow information to circulate throughout the organization. Its psychology is the shared beliefs, norms, and values that permeate the organization. As they state, simply
‘reconfiguring the formal structure is a blunt and sometimes brutal instrument of change’.7 What is required is first
to alter the organizational psychology—the beliefs and behaviours of individuals that pervade the organization.
These changes can then be reinforced by improving the organizational physiology, which involves improvements
in communication and decision making. Only then should senior managers realign the organizational anatomy by
making changes to its formal structure.
9.1.5 The Network Structure
Where an organization operates across many countries a transnational structure may be more effective in helping
a multinational corporation to respond to the needs of local markets and achieve efficiencies from globalization.
The transnational structure differs from the other organizational forms in that it neither dogmatically centralizes nor
decentralizes, but instead makes selective decisions. The transnational corporation was discussed in detail when we
looked at international strategies in Chapter 8.
Manufacturers
Suppliers
Head Office
–Broker
Designers
Figure 9.5 A network structure.
Distributors
9
A network structure involves a configuration of outsourced activities that are controlled by a central hub. This is
particularly useful in responding to fast-moving and unpredictable environments such as the fashion industry. The
network structure allows the capabilities of the organization to be retained at the centre while non-core activities are
outsourced to specialist firms which allows for greater efficiency (Figure 9.5). The major advantage of the network
structure is the flexibility it provides to organizations, enabling them to respond quickly to changes in the marketplace.
Organizations such as Nike and Zara both outsource manufacturing activities to specialist firms, while retaining tight
control at the centre over their distinctive capabilities.
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In recognition of the complex and fraught nature of organization design, Michael Goold and Andrew Campbell propose a framework to guide executive management.8 Their nine tests of organization design are based on their observations of different size companies. The framework is an attempt to help top management to evaluate their existing
structure or, indeed, a new structure objectively. The first four tests help executives to assess alternative structures by
seeing whether a proposed structure can support the strategy being pursued. The remaining five tests are used to
adjust potential organization designs by tackling problem areas, such as the problem of effective control that results
from increased decentralization. This framework is not a panacea, which Goold and Campbell acknowledge. Rather, it
is an attempt to de-politicize and depersonalize the process of organization design.
Organizational structures are invariably linked with the vision of the CEO who runs the company. When Jack Welch ran
GE, it was his understanding of the markets the company faced which determined the structure he put in place. Questions about structure and strategy are invariably linked (see Strategy in Focus 9.1). For example, Ikea’s CEO, Jesper
Brodin, faces the challenge of changing the location of stores from large out-of-town sites to smaller city centre outlets
with pick-up points to reflect changing consumer needs. At the same time, Internet purchases continue to make the
need for out-of-town sites less compelling.
STRATEGY IN FOCUS 9.1 IKEA’s Challenge over Strategy
9
and Structure
Ikea’s popular Ektorp three-seat sofa. Source: Inter IKEA Systems B.V.
When Ikea introduced the Ektorp sofa two decades ago, it cost €599. The same product, largely looking the
same, is still sold today. But thanks to clever tweaks—it can be flat-packed, with a hinged back and detachable
arm rests—it costs only €299. Something similar is going on with Ikea CEOs. The furniture retailer, born in
Sweden but now based in the Netherlands, is to have its sixth CEO in its seventy-four-year history. Jesper Brodin
is also of a certain, familiar mould.
He is a former assistant to Ingvar Kamprad, Ikea’s founder, comes from southern Sweden, wears a jumper
and shirt combo, and sounds slightly subdued in interviews, much like most of his predecessors. Still, Ikea is a
company in the midst of a great transformation. And Mr Brodin brings a valuable insight into the upheaval and
the challenges that will bring, having worked across Ikea’s complicated structure. Ikea has recently undergone
as big a shake-up as it has ever been through. Ikea of Sweden, headed by Mr Brodin and responsible for product
design, manufacturing, and supply chain, was sold last year by the retailer to its sister company Inter Ikea,
which is responsible for the brand and concept. Ikea itself is now, formally, little more than the world’s largest
franchisee for the flat-pack furniture group. But what a franchisee: Ikea operates 340 stores, vastly outnumbering
the roughly forty managed by other franchisees, and brings in €34 billion in annual revenues.
Mr Brodin says his new role will be about ‘focusing on the customer meeting’. But the nature of that meeting
is changing rapidly. From its first store in 1958 until recently, Ikea followed a tried-and-trusted recipe of placing
its stores near ‘the potato fields’ as its managers like to say, in out-of-town sites with big car parks next to huge
warehouses. Now Ikea is experimenting with other formats; smaller stores, city centre outlets, pick-up points, but
it is unclear how well these will work. Some customers are already criticizing the cost and selection. Tougher still
for Ikea is that many customers, such as millennials, no longer want to shop in store, but instead buy online. This
threatens a key element of Ikea’s success; its labyrinthine store layouts and infamous market hall are designed to
maximise impulse purchases of everything from wine glasses and picture frames to plants and napkins.
Ikea plays down the risks. Peter Agnefjall, the outgoing CEO, says annual visits to ikea.com have doubled to two
billion in his almost four years in charge. As with many retailers, Ikea’s buzzword is‘multichannel’, selling to customers
through physical stores, the internet, and combinations of the two. It is also targeting huge growth: its aim is to have
€50 billion of revenues by 2020, up from €34 billion in 2016, with even more stretching targets beyond that.
There are other big questions that Ikea will need to answer. One is whether the new division of labour between
Ikea and Inter Ikea will work. A senior insider says Inter Ikea could now use other franchisees to enter South America
and Africa. In any case, Inter Ikea, used to working in the shadows, now has an even bigger role in the Ikea system.
No matter how identikit Jesper Brodin may seem to his predecessors, he is facing a much changed set of challenges.
Another intriguing issue is Ikea’s sheer size. A former CEO, Anders Dahlvig, once suggested that Ikea could break up
into three separate companies covering North America, Europe, and Asia, each with their own product development
and supply chain. Mr Dahlvig, chief executive from 1999 to 2009, is now the chairman of Inter Ikea. Holding together
Ikea’s rather special tight-knit culture as it expands into new countries such as India and Croatia could be tricky, as
highlighted by scandals in its network of stores, including bribery allegations in Russia.
There are also concerns about the turnover in CEOs. Mr Dahlvig was only Ikea’s third CEO. Two more have
come and gone since. While Mr Agnefjall denies that the corporate shake-up played any role, the insider says
that some people have reacted negatively to moving from being an integrated company to a pure retailer.
‘Some people think it’s less interesting’, he adds. All this means that no matter how identikit Mr Brodin may seem
to his predecessors, he is facing a much-changed set of challenges. He will need more than an Allen key and a
sketchy set of instructions to succeed.
Source: Richard Milne, ‘Ikea must break the mould to overcome challenges’, Financial Times, 7 June 2017. Used under licence from the Financial Times. All Rights
Reserved.
9.2 Organizational Processes
The division of labour allows organizational activities to be separated out and common activities grouped
together. However, this creates a dilemma. While the level of coordination improves within a homogeneous group,
the level of coordination across different groups may decline. What is required is organizational integration which
allows coordination to occur effectively across an organization’s activities. This is not an easy task given that each
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9
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specialized group will have a tendency to seek its own goals and adopt behaviour to support this. One answer may
be to concentrate more on horizontal processes rather than organizational structure. Ghoshal and Bartlett argue
that top management has continued to focus on structural solutions, despite evidence that such structures can
become inflexible and unresponsive to change.9 As organizations grew and their divisional structure struggled
to cope with the increased complexity, management adopted a strategic business unit (SBU) approach. This was
a variation on the divisional structure which allowed senior managers to concentrate on specific businesses. The
problem was that this created business silos which impeded coordination across different business units. These
and other structural solutions simply failed to help the organization create an entrepreneurial culture, build capabilities, and to discard outdated ideas. The consequence of failing hierarchical structures leads to downsizing as
organizations seek to remove non-performing layers.
9
Ghoshal and Bartlett studied twenty organizations in the US, Europe, and Japan which understood the importance of
processes over structures. They identified three distinct processes: entrepreneurial process, competence-building process, and renewal process. Together they constitute what Ghoshal and Bartlett refer to as a firm’s ‘core organizational
processes’.
1. The entrepreneurial process.
This seeks to motivate employees to manage their operations as if they belonged to them. This requires a
change in the current role of managers as simply implementers of strategy with only the most senior managers
having the authority to initiate new ideas. To institute an entrepreneurial process requires a culture that recognizes the capabilities of individuals in the organization. Top management needs to understand that individuals
perform more effectively when they are trusted to work, utilizing their own self-discipline rather than a formal
control system.
A self-disciplined approach requires that top management adopts a supportive role. This does not mean that
no control systems exist. For example, 3M uses small project teams to foster creativity and entrepreneurship.
These project teams include someone with an innovative idea, and a few individuals who want to support it. If
the idea takes off, the project team may eventually grow into a department or division. However, this entrepreneurial activity is set within the context of clear corporate targets, such as contributing to a twenty-five-per-cent
return on equity. At Google, they use 10x, which stands for doing things ten times better instead of focusing on
incremental change. This approach helps Google to improve its technology and deliver better products for users
by giving employees permission to think big and not be afraid to come up with new solutions.
2. Competence-building process.
Large organizations need to be able to exploit the vast amount of employee knowledge that exists in their different businesses. This requires a competence-building process which coordinates the distinctive capabilities across
those businesses. The employees within the individual businesses need to be given the task of creating these
competencies. This recognizes their closeness to the customer and hence greater ability to exploit local opportunities. As with the entrepreneurial process, the role of senior management is to ensure that the competencies are
coordinated across different business units.
Senior managers must also ensure that their control systems are fair and transparent to encourage risk-taking.
Individual employees need to adopt the organization’s values and goals to help build a sense of community. This
type of culture can only exist if it is nurtured by top management. For example, throughout the Japanese organization Kao there are open meeting areas. This entitles every employee who has an interest in a subject being
discussed to sit in on a meeting and contribute their ideas.
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3. The renewal process.
This process ‘is designed to challenge a company’s strategies and the assumptions behind them’. This requires
senior management to proactively shake up the organization’s status quo. Their role is then to mediate the
resulting conflict that will inevitably arise. Intel’s move away from memory chips and towards microprocessors
represents a renewal process. The organization was founded on memory chips. The decision by co-founder Andy
Grove to re-base the organization on microprocessors directly cut across entrenched views of what Intel stood
for. A result of emphasizing process over structure is to create an organization in which individual employees are
willing and able to innovate. They will share new ideas and knowledge, and work towards common organizationwide goals. This occurs without the constant intrusion of managerial control systems.
9.3 Strategic Control Systems
A well-designed reward system can be instrumental in successful strategy implementation. That said, a great deal
of contention has arisen over rewarding executives for achieving lacklustre results and revising performance targets
downwards to enable them to be more easily met. A reward system should recognize an individual’s or group’s achievement and motivate them to work towards the organization’s goals. Where individuals are already highly paid, a reward
system has to move beyond merely pecuniary factors to keep them motivated. A tension exists between the shortterm quarterly targets on which managerial rewards are commonly based, and getting managers to adopt longer time
horizons which more effectively exploit opportunities in their business environment. We saw in Chapter 4 the use of
a balanced scorecard is helpful in moving managerial attention away from purely financial concerns to consider other
issues that impact upon the business, such as customer retention.
Strategic control systems include similar elements to budgetary control systems, but they involve longer-term objectives. This can create difficulties because managers will be more inclined to invest their time in achieving short-term
targets than targets that are many years off. To overcome this, strategic control systems can include a series of shortterm milestones that need to be achieved if a strategy is to be implemented. In this way, the management reward
systems can be aligned with the implementation of the strategy. Goold and Quinn suggest three reasons for establishing control systems.11
1) A strategic control system should coordinate the activities of members of an organization.
Where the nature of strategic change is emergent and incremental rather than planned and precise, strategic
control systems need to be designed to reflect this.12 On the one hand, strategic control systems must be loose
9
The design of all organizations must include control and reward systems, which ensure that members of an organization are actively working to achieve the corporate goals. Control systems are necessary for senior managers to
be able to assess the performance of individual business units. A control system will include agreed objectives
between senior managers and managers of business units, and a mechanism for monitoring performance based
on these objectives and for providing feedback to managers. It will also include a system of rewards and sanctions that motivate managers and make them aware of the consequences of not meeting agreed targets. Most
organizations use budgetary controls which measure and monitor financial performance. However, as we saw in
Chapter 4, financial controls need to be used with broader strategic controls if important competitive information
is not to be overlooked.10
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enough to deal with dynamic environments such as the software industry. On the other hand, they must be rigorous enough to allow effective control to take place.
2) A strategic control system should motivate managers to achieve their agreed objectives.
Research has shown that clearly defined goals result in improved performance. These goals should be objectively
measured and involve a challenge for individuals. They should neither be perceived as too easy, nor insurmountable. Allowing participation in setting objectives for complex tasks also helps improve performance. When
addressing the goals of business unit managers, the strategic controls should focus on a few results-orientated
goals which help guide behaviour. These can be financial and non-financial.13
However, this approach is less helpful in circumstances where the business output is difficult to measure and
what constitutes results is unclear. In such a case organizations may choose not to use strategic control systems,
but instead adopt what William Ouchi calls clan controls.14 This is where individual members of a clan have shared
values, which ensure that they pursue organizational goals without the overt need for a system of control. New
members joining the organization are socialized into the values of the clan.
3) A strategic control system helps senior managers know when to intervene in the decisions of unit managers.
In theory, a useful strategic control system needs to be able to continually assess the assumptions on which
a strategy is based, as well as monitor management objectives. In reality, rather than undertake this kind of
in-depth analysis, senior managers prefer to use their intuition and business experience to help them decide
when to intervene in businesses.
9
However a control system is designed, we might bear in mind that all control systems stand or fall according to the
level of trust they embody. Trust is the key ingredient in all effective control systems.
Goold and Quinn suggest that managers may need to adapt strategic control systems to different business conditions. They point out that while in theory there are benefits to be derived from a strategic control system, in
reality there are difficulties in trying to devise one. These difficulties are likely to be more pronounced in certain
sorts of businesses. This implies strategic control processes may need to be designed to take account of the specific circumstances faced by each business.15 Their solution is a framework for a contingency theory of strategic
control, highlighting the conditions under which strategic control systems might be useful for an organization
(Figure 9.6). It compares environmental turbulence with the ability of senior managers to state and measure
strategic objectives.
The ideal use of strategic controls is when the environment faced by the organization exhibits low turbulence and it
is easy to state and measure precise objectives. In this type of organization, a formal strategic control system can be
designed which will help monitor strategy implementation. In addition, because strategic objectives can be stated
and readily measured, the strategic control system can be used to set goals and motivate managers. This is shown
in the lower left-hand quadrant of Figure 9.6. In organizations where the environmental turbulence is high and the
ability to specify objectives is easy, a strategic control system may still be of benefit, but needs to be more loosely exercised. This reflects the dynamic nature of the environment in which the organization operates.
Where the organization faces an environment in which turbulence is low, but there is difficulty in specifying and measuring objectives, strategic controls can act as a means of monitoring strategy. This might be done through the use of
Environmental
Turbulence
CHAPTER 9 Organizational Structures and Strategic Change
High
Low
• Strategic control system
valuable, but should not
be tightly administered
• Strategic control system
problematic
• Strategic control system
valuable
• Strategic controls more
for tracking progress than
motivation
Easy
251
Difficult
Ability to Specify and Measure Precise Strategic Objectives
Figure 9.6 Approaches to strategic controls in different sorts of businesses. Source: M. Goold and J. Quinn, ‘The paradox of strategic controls’, Strategic
Management Journal, 11 Jan. 1990. © John Wiley & Sons Ltd.
milestones or signposts. Finally, in organizations which exhibit high turbulence and a difficulty in measuring objectives, strategic control systems pose a real problem. The difficulty in measuring objectives precludes their use as a
motivational vehicle for managers. In this case, a looser arrangement is required that emphasizes informal relationships between senior managers and unit managers. Therefore, a strategic control system may be best thought of as
contingent upon the business environment the organization faces.
In addressing control systems, Chris Argyris makes the point that organizations need to move beyond what he calls
single-loop learning.16 This occurs when firm performance is measured against agreed goals. Feedback is obtained only
after seeing whether the goals have been met at the end of a specified period (e.g. a quarter). Until this time has elapsed,
no action to change strategy or goals is taken. In a stable and relatively predictable environment a single-loop control
system would not be a cause for concern. However, in an environment characterized by greater change and uncertainty, single-loop learning is inappropriate. Argyris argues instead for double-loop learning in which learning becomes
a continuous process. As part of double-loop learning the assumptions on which strategies and goals are based are
continually challenged and monitored. This allows the organization to detect and respond to changes in its environment more readily.
The more formal an organization’s structure, the more constrained are its members, particularly in networking across
functions to provide innovative solutions to business problems. The less prescribed an organization’s structure, the
more autonomy and flexibility its members have to cross boundary lines in pursuit of knowledge and capabilities.
Therefore, the more likely it is that an innovative culture can be encouraged. However, a conflict arises as to how ‘loose’
an organization’s structure should be before it impacts negatively on individual members’ roles. One solution is a
loose–tight structure: tight, in that there is an unflinching pursuit of the organization’s objectives; loose, in that there
is flexibility as to how these will be achieved.
The former chairman and CEO of Google, Eric Schmidt, argues that as Google grows older so its capacity to
innovate quickly may start to suffer. This is because there is a natural tendency to become more conservative as
an organization grows older, leading to it becoming more risk averse, taking small steps instead of big strides.
9
For a further discussion of strategic control systems, visit the online resources and see the
Extension Material for this chapter.
www.oup.com/uk/henry3e/
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Schmidt argues, ‘true innovation comes from doing things differently, often radically different, and that involves
risk’. Google has what they call twenty per cent time, which allows its engineers to spend around one day a week
working on things they find interesting. To date this has produced innovations such as Google Chrome, developed
by the current CEO, Sundar Pichai.
It is often said by leaders of organizations that people are their most valuable assets. It is a truism that without
the actions of individual members of an organization a strategy cannot be effectively implemented. The question
thus arises: how much support do organizations provide to their employees? And what impact does an organization’s commitment to its employees have on organizational performance? Jangwoo Lee and Danny Miller suggest that an organization’s commitment to its employees can be seen in the way that it cares for employee welfare
and satisfaction, the fairness of its rewards, and the investment it makes in their development and compensation.17 Their study of the competitive strategies of Korean firms found that an organization’s commitment to its
employees provides only a small financial benefit to the organization. However, when an organization’s commitment to its employees is aligned to a dedicated positioning strategy, its potential for achieving a competitive
advantage improves. Not surprisingly, they found a ‘strategy appears to be necessary to channel effort to achieve
the maximum benefit’.
9
This suggests that a loyal and committed workforce implementing a dedicated strategy may be a basis for
improved profitability. This is because a dedicated strategy is implemented more effectively by an organization
which shows a commitment to its employees. While an organization’s commitment to its employees has a positive impact on its return on assets in the context of an intensive positioning strategy. This study also suggests
that the resource-based view and positioning approach to strategy both have their part to play. An asset-specific
resource, such as a motivated workforce, can help in the implementation of a positioning strategy, while a positioning strategy is clearly necessary to channel the efforts of employees. However, a sense of trust that emanates
from an organization’s commitment to its employees and their commitment to the organization’s success takes
time to establish. The Case Example: W. L. Gore’s Unconventional Success at the end of the chapter highlights
the counter-intuitive approach of leading a company without traditional organizational structures and strategic
control systems.
9.4 Strategic Change
Strategic change is about changing the way in which an organization interacts with its external environment. It is
about creating new and innovative ways of doing business. It involves changing an organization’s systems in order
to adapt to external changes. Organizational systems may be divided into three elements: (1) structure; (2) processes; and (3) culture. Organizational structure is concerned with the division of labour into specialized tasks and
coordination between these tasks. Organizational processes deal with the control systems to manage employees
and guide their behaviour to ensure that the firm achieves its goals. This will include such things as budgeting and
formal planning. Organizational culture can be thought of as the shared norms and values adopted by the members
of an organization. In the absence of formal control mechanisms, values and culture can be a powerful force in
motivating and guiding behaviour.18
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Strategic change is necessary for an organization to ensure a fit between its internal resources and capabilities
and the requirements of a changing environment. However, the organization should not be seen as passive, simply responding to changes in its environment. An organization may instead seek to actively influence its competitive environment. It may seek to drive the changes taking place in its industry. For example, Gillette constantly
redefines the rules of the game by actively destabilizing existing competitive advantages in its industry. In implementing strategic change, organizations need to consider the size of any change and the speed with which that
will be undertaken.
In a classic article, Larry Greiner argues that as organizations grow they go through five distinct phases of development.19 These phases are characterized by relatively calm periods of growth that end in a management
crisis. The extent to which these crises can be anticipated will depend upon how well management knows its
own organizational history. This is because each phase is influenced by the preceding phase. As an organization grows, it proceeds through evolutionary change and revolutionary change. How managers tackle each
revolutionary change will determine whether or not the organization will proceed to the next evolutionary
change.
In contrast, evolutionary change describes ‘prolonged periods of growth where no major upheaval occurs in
organizational practices’.21 It involves a series of small, gradual changes. However, the end result may be the same
as for revolutionary change. This is because the accumulated effect of many small changes is similar to making
one large change. The main difference is the timescale it requires to undertake the changes. The rationale for
evolutionary change is best seen by addressing how individuals learn. Most individuals learn incrementally
over a period of time. By definition an organization, which is fundamentally a collection of individuals, learns
in the same way. If individuals are to internalize change for the benefit of organizations, they need time to
learn.
Greiner contends how an organization develops is determined by the interactions between its age, its size, its stages
of evolutionary and revolutionary change, and the growth rate of its industry. The task of managers during each revolutionary change is to develop a new set of practices that will help them to manage in the next evolutionary growth
period. However, each new management practice will eventually become obsolete for managing change in the next
growth period. As Greiner states, ‘managers experience the irony of seeing a major solution in one period become a
major problem in a later period’.22
The five phases of growth identified by Greiner are: (1) creativity; (2) direction; (3) delegation; (4) coordination; and (5)
collaboration (Figure 9.7).
9
Revolutionary change describes ‘those periods of substantial turmoil in organizational life’.20 It involves a break with
existing business practices which occurs over a short period of time. It is usually a response to changes in the external
environment, such as a shift in the use of certain technologies. It may also occur as a result of internal changes in the
organization. For instance, a new CEO often has a window of opportunity in which he or she can push through fundamental changes in the way the organization delivers its products or services. When this window closes organizational
inertia often precludes radical change.
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PHASE 1
PHASE 2
PHASE 3
PHASE 4
Large
PHASE 5
5. Crisis of
?
Evolution stages
Revolution stages
4. Crisis of
RED TAPE
Size of organization
3. Crisis of
CONTROL
5. Growth through
COLLABORATION
4. Growth through
COORDINATION
2. Crisis of
AUTONOMY
3. Growth through
DELEGATION
1. Crisis of
LEADERSHIP
2. Growth through
DIRECTION
1. Growth through
CREATIVITY
Small
Young
Age of Organization
Mature
Figure 9.7 The five phases of growth. Source: ‘Exhibit II: The five phases of growth’, in L. E. Greiner, ‘Growing Organizations’, Harvard Business Review, vol. 50,
no. 4 (1972). Copyright © 1972 by the Harvard Business School Publishing Corporation. Reprinted by permission of Harvard Business Review. All rights reserved.
9
Phase 1 Creativity
This is characterized by product development and market growth. Communication between individuals in the
organization is informal, and tasks are less clearly defined. The founders of the organization spend their time on
the product or service and neglect managerial functions. As the organization grows the founders are unable to
keep pace with the increased managerial functions, such as finance, marketing, and manufacturing. At this point
a crisis of leadership occurs, which is the basis for the first revolutionary change. A manager is needed to lead the
business who has knowledge and experience of managing these different functions. Success in Phase 1 leads the
company to Phase 2.
Phase 2 Direction
The evolutionary growth phase is characterized by the implementation of a functional structure with clear lines
of responsibility and authority. Communication becomes more formal. Organizational hierarchy becomes prevalent, reinforced by control systems. As the organization continues to grow, so these existing structures become
increasingly cumbersome. The growing complexity of the environment requires individual employees to exercise
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their discretion in making decisions. A crisis of autonomy results in a second revolution which is born out of the
conflict between autonomy and tight control systems.
Phase 3 Delegation
This is epitomized by a decentralized structure. In fact, in an update to this article, Greiner suggests that decentralization sums up more clearly than delegation what is occurring in this phase.23 Managers experience greater
autonomy and responsibility. Motivation is achieved through a bonus structure that rewards business goals. In
time, however, executive managers at the centre perceive a tendency for business managers to subordinate the
overall corporate goals in favour of their own business goals. This leads to a crisis of control, in which top management seek to assert their control.
Phase 4 Coordination
Executive managers institute formal control systems to help them coordinate these diverse businesses. These
decentralized business units may be reconfigured into product groups. The allocation of resources is far more
carefully evaluated and controlled at the centre. The return on capital employed is used by the centre as a
criterion for justifying their allocation decisions. In time, this leads to a crisis of red tape in which business unit
managers come to resent decisions from the centre, which are seen as remote and lacking an understanding of
local market conditions. The organization becomes too big and complex to be efficiently managed by formal
systems—the next revolution begins.
Self-discipline and working towards agreed organizational objectives replace formal control systems. Teamwork,
flexible working, and networking are common practices characterizing this evolutionary growth phase. The question for leaders of organizations is what kind of revolution change will supplant this evolutionary growth phase. A
real difficulty for leaders is to understand where they are in this development process and consciously act to learn
from, rather than replicate, the past. Although the rate of change has accelerated since Greiner first introduced his
model, it does provide an outline of the broad challenges that managers of growing organizations face.24
Those who advocate revolutionary change accept that all firms need periods of relative stability, but argue that
this can breed rigidities. Organizational rigidity is an inability and unwillingness to change even when your
competitive environment dictates that change is required. For example, Blockbuster’s inability to adapt to the
online streaming of films. In addressing strategic change, tools such as business process re-engineering can help
managers to see that change must be integrative across the organization’s systems rather than be conducted in
isolation (see Section 9.4.1, ‘Integrative Change’). A challenge for managers of revolutionary change is to avoid
the organization sinking back into old rigidities after the change. As we saw in Chapters 3 and 6, companies that
compete in disruptive environments are forced to innovate constantly. This leaves little room for complacency
and resting on former successes.
Those who advocate evolutionary change see revolutionary change as perpetual; another similar-size
change will eventually be required after the firm sinks back to its old ways. They also point out that such
revolutionary change is difficult to sustain and simply awaits another business issue to grab the organization’s attention (see Strategy in Focus 9.2). In contrast, evolutionary change focuses on the organization’s
long-term goals and moves towards this. Individuals are still expected to learn, share ideas, and engage in
innovation. Evolutionary change should embrace all members of an organization. The role of management is
to support and facilitate this learning and continuous improvement.
9
Phase 5 Collaboration
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STRATEGY IN FOCUS 9.2 Has Apple’s Revolution Come
to an End?
How do you replace Steve Jobs? People had tried before and failed:
when Apple’s founder left amid a boardroom coup, the string of leaders
that filled the void almost brought the company to its knees until Jobs’
triumphant return over a decade later. So, when Jobs’s hand-picked
successor Tim Cook took command in 2011, it was always bound to be
one of the most scrutinized handovers in corporate history.
Jobs was seen as an icon of leadership and innovation. He had been
central to the polished icons of twenty-first century computing: the
iPod, iPhone, and iPad, bringing a flair that had made them seem like
more than mere combinations of glass and metal. Cook, meanwhile,
was the less-visible chief operating officer; the master of the supply
chain who rose at 4.30 a.m. every morning to keep the well-oiled
machine ticking over. And though he was the obvious candidate to
replace the irreplaceable, analysts doubted whether he would be able
to keep the Apple magic alive. Years later, the same questions persist.
Few would deny he was the right man for the job, but under Cook,
Apple is yet to release an undisputed hit product.
9
The World’s Biggest Company
While the line-up of products in Apple’s stores bears a resemblance to
that of five years ago, the company Cook runs has been transformed.
Under his tenure, Apple has become the world’s largest public
company, and twice broken the record for the biggest quarterly profit
in history. The company has also doubled in size. During Jobs’s final On the 24th August 2011, Tim Cook become
full quarter as CEO, Apple sold 20.3 million iPhones; in 2016 it sold the CEO of Apple Inc. Source: © Laura Hutton/
more than double that. Its 110,000 staff today compare to just over Shutterstock.com
60,000 in 2011. When Jobs passed the baton, it had four stores in
China, compared to forty-one in 2016.
This monumental expansion has also put pressure on Apple over taxes and its swelling overseas cash pile, which
Cook has said he is not ready to repatriate to the US without US reform, despite pressures from agitated investors to
return more money to shareholders. The challenge has required a steady hand. Cook has had to appear in front of
US politicians at high-profile hearings and charm European politicians investigating its tax affairs, as well as appease
grumbling investors. His record here has been impressive: Apple’s share price has more than doubled under Cook.
Apple is known for the life-changing product, the thing that consumers don’t know they want until they
see it. When Jobs stepped down, the key question was whether Apple would be able to continue its hot streak,
and five years later, the jury is still out. One of the company’s first releases under Cook was the disastrous Apple
Maps, which missed entire towns and important transport links. Cook’s most significant new product has been
the Apple Watch, which to date has proved to be more of a product for committed consumers than a worldwide
phenomenon. Apple’s ability to keep moving upwards has instead been rooted in growing sales of the iPhone.
But the iPhone now makes up more than half of Apple’s sales, more than it did when Jobs stepped down, leading
some to question whether Apple is over-reliant on one thing.
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The smartphone market has begun to saturate; after a thirteen-year streak of rising revenues, Apple’s sales
have begun to fall. While Apple has continued to refresh its top products with new features, there is never likely
to be another iPhone. Instead, Cook has focused on selling more of the software and services that live on the
iPhones in use today. Sales from apps and services continue to increase. The services business includes Apple
Music and Apple Pay, two of the more successful new products Apple has launched under Cook, and is now
bigger than both the iPad and Mac computers.
Source: James Titcombe, ‘How Tim Cook has changed Apple in five years’, The Telegraph, 23 August 2016. © Telegraph Media Group Limited. Reproduced
with permission..
9.4.1 Integrative Change
Information technology is often introduced by organizations seeking to address deteriorating business performance.
Michael Hammer’s work on business process re-engineering warns against naively using new technology with outdated business practices to boost performance.25 Instead of seeing technology as a panacea, it should be viewed as a
tool to help radically redesign business processes. As he states:
Reengineering strives to break away from the old rules about how we organize and conduct business …
reengineering cannot be planned meticulously and accomplished in small and cautious steps. It’s an all-ornothing proposition.26
What is required is an understanding of the interactions and interdependencies between departments. This
requires a change management team that is drawn from the units involved in the process being re-engineered, as
well as the units that depend on them. This is in order to assess which processes add value. Re-engineering involves
a shift in thinking about organizational structure in which the people who undertake the work make the decisions.
These individuals would then become self-managing and self-controlling, which allows for management layers
to be depleted. It also changes the management role from one of control to one of support and facilitation. Given
the disruption and discontinuity of this sort of revolutionary change, re-engineering requires leaders who possess vision. Such leaders are not afraid to adopt audacious goals and possess the drive and ability to see them to
completion.
Erik Brynjolfsson and his colleagues argue that effective change requires an understanding of complements that exists
between strategy, technology, and business practice.27 They suggest management would benefit from adopting a
matrix of change approach to help them understand the complicated interrelationships that surround change. Their
framework draws upon the work of Paul Milgrom and John Roberts on complements.28 This suggests that in implementing complex change, managers needs to take account of the interactions that exist between business practices,
9
Hammer argues for a revolutionary approach to change in which management are prepared to embrace an uncertain
future. Re-engineering calls for senior management to question the assumptions of their existing business processes
and change outdated rules. We have seen that specialization in organizations tends to lead to a subculture in which
organizational goals are replaced by their department goals. In re-engineering the fundamental processes of the firm
needs to be addressed from a cross-functional perspective. Otherwise, any attempt to change a poorly performing
department in isolation will be prone to failure.
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rather than trying to implement change in a disaggregated fashion. The matrix allows managers to think through the
following change issues before attempting implementation: (a) feasibility—the coherence and stability of any proposed change; (b) sequence—the order in which change should take place; (c) pace—the speed with which change
should be undertaken and the magnitude of change; and (d) location—whether a proposed change should take place
at an existing or a new site.
The drivers of organizational change, which include information technology and increasing competition, have
brought about new organizational forms. Where these forms constitute a discontinuity, or break with old practices, the
benefits to organizations can be considerable. For example, Hallmark, which produces greeting cards, gift wrappings,
and other personal expression products, was able to reduce the time it takes to introduce new products by seventyfive per cent. This was achieved by changing their practice of sequential product development to one involving a
cross-functional team. A difficulty arises, as we saw earlier, when organizations introduce technology without thinking
through the contingent changes in working practices. This is one reason why US firms have failed to obtain the same
benefits from introducing technology that comparable Japanese firms achieve.
A matrix of change system involves three matrices: (1) an organization’s current practices; (2) its proposed or target
practices; and (3) a transitional state that helps an organization move from matrix (1) to matrix (2). In addition, the
matrix system includes stakeholder evaluations which provide employees with a forum to state the importance of the
practices to their jobs. The matrix of change helps managers to be aware of the assumptions that underlie how their
organization works. Its value is in identifying complementary and competing practices.
9
Complementary practices are reinforcing. This means that undertaking more of one complement increases the return
to the other complement. In contrast, doing less of a competing practice actually increases the return to other competing practices. In making complementary and competing practices explicit, managers can immediately see where
there is likely to be reinforcement or interference between existing and target practices. This allows managers to select
the practices which will be most effective in meeting organizational goals.
Therefore, to achieve superior performance we require an understanding of change that takes into account a complete
and coherent system of practices. However, we need to recognize that organizational performance may experience a
decline as new complements disrupt the old ways of doing things. In this respect, putting together a coherent set of
complements may take a number of years. This is not to say that change must always be evolutionary, since a powerful
leader with a strong vision may introduce rapid system-wide change.
9.4.2 Strategic Drift
In discussing the challenges surrounding strategic change, Gerry Johnson introduces the term strategic drift.29 This
refers to a situation in which the strategy being pursued by an organization becomes less relevant to the environment
in which the organization competes. The process may take a number of years and not be perceived by managers
until the drift causes company performance to decline. At this point, the situation is likely to require a transformation
change in strategy. Strategic drift occurs because managers are wedded to their existing paradigm.
A paradigm is a set of beliefs and assumptions managers hold which are relevant to the organization in which they
work. It is the culture or ‘taken for granted’ view that is held by members of the organization about the company and
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259
its business environment. The paradigm develops overtime and encompasses all aspects of the company; for example, its management style and organizational routines. Ironically, it is more likely to be visible to those outside the
company than to those immersed in the culture inside the organization. Peter Drucker refers to this as a company’s
‘theory of the business’.30
Managers have a tendency to discount evidence contrary to the paradigm and embrace evidence that supports
the paradigm. This is often referred to as ‘cognitive bias’. This is because change within the paradigm is comfortable for managers. Therefore, they will interpret any uncertain event by looking for familiar patterns in which
they tackled similar events. As a result, any strategic change will be based upon what the organization has successfully achieved in the past. This will reinforce the belief in the need for incremental change. And, since the
organization is making incremental changes, managers can cite this as evidence that some change is taking
place within the organization.
If the markets in which the organization competes are changing gradually then gradual changes in strategy will
make sense to managers. This is shown in Figure 9.8 as the incremental change stage. At this stage, there is little misalignment between the organization strategy and the needs of its markets. In the next stage, strategic drift begins
to occur. The organization’s strategy is gradually moving away from its business environment. This is because the
environment is changing more rapidly than the change in the organization strategy. A reason for this may be due to
core rigidities; these are the capabilities on which the organization’s competitive advantage is based and therefore
difficult to change. This is because inherent within these capabilities will be emotional capital invested by managers
throughout the organization. These capabilities are often entwined with the organization’s DNA. An example of a
core rigidities is Intel’s difficulty in moving from memory chips to microprocessors. Another reason will be managers’
cognitive bias, mentioned above.
9
Change in the Business Environment
The next phase may manifest itself in deterioration in performance. As this drift becomes apparent the strategy of
the organization may enter a period of flux. During a period of flux, there is no clear strategic direction and internal
Change taking place
in business
environment
Transformational
change
Bankruptcy
Change to
strategy
Incremental Change
Strategic Drift
Time
Flux
Transformational
Change or
Bankruptcy
Figure 9.8 Strategic drift. Source: Adapted from G. Johnson, ‘Managing strategic change—strategy, culture, and action’, Long Range Planning, vol. 25, no. 1
(1992), pp. 28–36, p. 34.
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arguments intensify about the strategic direction of the firm. As performance continues to deteriorate, a radical transformation is required to align the organization’s strategy with its customers and markets. The final stage is one of transformational change or bankruptcy. At this point, the organization’s strategy is substantially misaligned with changes
in its business environment. Managers are faced with fundamentally rethinking their business model in light of the
disruptive changes in the business environment. Organizations infrequently undertake transformational change and
usually as a result of substantial losses in market share and profitability. If managers in the organization are unwilling
to accept this change, the company will likely cease to trade. Managers may hope for white knight: a rescue of the
company by another organization.
To avoid strategic drift, it is necessary to surface the assumptions that underlie the dominant paradigms. By making
assumptions about business decisions explicit, managers can then openly discuss the barriers to change. These barriers might be political, or part of the control systems, or indeed, any aspect of the organization. The crucial point is that
the dominant paradigm cannot be challenged or changed until its assumptions are made explicit.
Gerry Johnson and his colleagues undertook research to ascertain whether companies can undertake strategic
change without the advent of a crisis.31 They researched high-performing companies that successfully transformed
themselves in order to find out which management capabilities companies need to develop over time. They found
such companies had three fundamental advantages over their peers.
9
1) A tradition of creating alternative coalitions
Such companies had an ability to maintain their performance while pursuing strategic change. This was possible by creating parallel coalitions of top executives. The first coalition comprised senior executives, who were
focused on reinforcing current capabilities, strengths, and successes. The second coalition were younger, but also
executives. Their role was to develop new strategies and capabilities. Over time, this parallel behaviour becomes
institutionalized within the company. The outlook of the second coalition allowed them to anticipate strategic
drift where their strategy was misaligned from their changing business environment.
2) A tradition of constructively challenging business as usual
The companies achieved major transformations with those that were prepared to tolerate a challenge to their
existing ways of competing. Disagreements among the alternative coalitions, mentioned above, would over time
become less confrontational and more respectful. Therefore, what might have started as open conflict evolves
into constructive challenging.
3) A tradition of exploiting happy accidents
Happy accidents are ‘unanticipated circumstances or events that ultimately support transformation in the direction favoured by the leaders in waiting’. In effect, executives were able to take advantage of unforeseen events in
a way which allowed them to galvanize support for their ideas.
It is important to understand that these capabilities are developed over the long term. In order for such capabilities to be embedded within the organization, managers will have to establish their own traditions.
9.4.3 Visionary Organizations
What is it that makes an organization the best in its industry and widely admired by its peers? Where does the resilience that allows some companies to overcome adversity come from? Why do some companies make a lasting impact
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on the world around them? The answers to these questions are part of what determines a visionary organization.
Research by Jim Collins and Jerry Porras suggests that visionary organizations are particularly adept at simultaneously managing continuity and embracing change.32 Using responses from CEOs they identified eighteen visionary
companies, those with superior long-term performance who have made an impact on society. These were then compared with a control group of companies that had similar products, services, and markets when they were founded.
In common with the visionary organizations, the comparison companies were also identified by the CEOs that Collins
and Porras surveyed. The difference is that these companies were mentioned less often by CEOs when identifying
who they considered to be great companies. The comparison companies had an average founding date of 1892,
compared with 1897 for the visionary organizations.
The idea was to identify the factors that distinguish visionary from non-visionary companies. We might add that
although the comparison companies did not attain the same performance heights as the visionary companies, nonetheless they outperformed the stock market. The difference is that, whereas the comparison companies outperformed the stock market by a factor of more than two, the visionary companies outperformed it by a factor of more
than fifteen. Collins and Porras found that the visionary companies, which include Sony (the only non-US firm in the
study), the Walt Disney Company, Merck, 3M, Hewlett-Packard, and Ford, have a core ideology that comprises their
core values and purpose.33
The core values can be thought of as the principles on which the firm was founded. An organization’s purpose is the
reason why it exists, which transcends merely making money. The core values of an organization do not change; they
are the bedrock of the organization. Similarly, visionary organizations pursue their purpose knowing that this is on
going and will never be fully achieved. John Young, former CEO of Hewlett-Packard, sums up the thinking of visionary
companies.
Core values and purpose are important for visionary organizations in that they help to guide continuity, but also provide a stimulus for change. In Chapter 1 we mentioned the importance of Johnson & Johnson’s credo, a set of core
values that guides all members of that organization. The credo was applied in helping Johnson & Johnson to make
an appropriate decision during the Tylenol issue. Visionary companies are prepared to change everything, except
their fundamental core values. Their strategy, structure, practices, resources and capabilities, and systems all need to
change at some point to ensure forward momentum or progress. For visionary companies this drive for change comes
from within—a constant dissatisfaction with the status quo—rather than a reaction to the external environment.
How do such organizations stimulate change? The answer is that they institute BHAGs—big hairy audacious goals.
These are clear, stretching goals that can be easily communicated to everyone in the organization. For example, Henry
Ford wanted ‘to democratize the automobile’ by giving the majority of individuals the freedom to buy a car. This was
For information on the role of BHAGs in stimulating change, go to the online resources and see the
Extension Material for this chapter.
www.oup.com/uk/henry3e/
9
We distinguish between core values and practices; the core values don’t change, but the practices might. We’ve also
remained clear that profit—as important as it is—is not why the Hewlett-Packard Company exists; it exists for
more fundamental reasons.34
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in 1907, when Ford was not the dominant player in the industry. The irony is that Ford failed to replace this BHAG with
another to continue to stimulate progress and lost its market dominance to General Motors. Therefore, BHAGs need to
be continually updated to avoid organizational complacency.
Gary Hamel and C. K. Prahalad make a similar point using the concept of strategic intent.35 As with BHAGs, strategic
intent is more than mere rhetoric. It requires a major level of commitment from the organization to pursue these
over-arching goals. Although these goals will invariably involve a longer-term time horizon, BHAGs and strategic
intent help provide some consistency to short-term actions. The example of Boeing’s decision to build the jumbo
jet, the 747, when failure would have meant bankruptcy, represents a most audacious goal. Its rival, McDonnell
Douglas, tended to adopt a more cautious wait-and-see approach. In short, BHAGs fall outside an organization’s
comfort zone. They are consistent with its core ideology, and help stimulate progress by maintaining forward
momentum.
9
Visionary companies embrace what Collins and Porras refer to as the genius of the ‘AND’, rather than succumb to
the tyranny of the ‘OR’. In other words, where rival corporations see paradoxes and conflict, visionary companies
succeed in achieving synthesis. For example, visionary companies actively pursue their ideology and profit. Being
idealistic is not a reason for them to sacrifice the pursuit of profits. Although much is often made of the role of
charismatic leaders in shaping organizations, it was found that this was not the case in visionary companies. At
various times throughout their history organizations such as 3M, Procter & Gamble, Merck, and Sony have had
CEOs who made significant changes, but were not what might be understood as high-profile charismatic leaders. In fact, by setting BHAGs that are independent of management style the succession of charismatic leaders
proves far less of a problem. Of course, as was evident with Peters and Waterman’s ‘In Search of Excellence’, the
fortunes of such companies can quickly change. The danger of emphasizing specific companies, such as Sony and
Hewlett-Packard, is that changes in their environment quickly turn today’s darlings into tomorrow’s dogs. As such,
we need to recognize that being overly prescriptive about visionary organizations can quickly date the relevance
of research.
In addition, Collins and Porras also found a cult-like culture in visionary organizations. This cult-like culture is built
around the core values of the organization. It constantly reinforces the core ideology of the organization through
socialization. It indoctrinates the employees in the ways of the company and thereby influences their attitude and
behaviour. This is manifest in organizations like Walt Disney, Procter & Gamble, and Wal-Mart. Organizational culture
can be defined as ‘the pattern of basic assumptions that a given group has invented, discovered, or developed in learning to cope with its problems of external adaptation and internal integration’.36 It can be thought of as the values and
beliefs that members of an organization hold in common. The outward manifestations of organizational culture can
include such things as dress code, employee inductions, symbols, and office layout. However, to gain a deeper understanding of culture, it becomes necessary to investigate the assumptions that guide how members of an organization
perceive, think, and feel.
A strong sense of culture or shared values, such as exists at Procter & Gamble, can help to coordinate, motivate, and guide individual behaviour. This invariably precludes the need for formal control systems to manage
employee behaviour. There are similarities with the Theory Z Japanese style of management.37 A Theory Z-typeorganization is based on trust. Therefore, it requires a less hierarchical structure which in turn helps to engender
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263
greater employee involvement. A key characteristic of a Theory Z organization is its informal control systems
reinforced by formal measures.
An organization’s culture can be a force for change and innovation, but it may also be an impediment to
change. For example, the culture that exists within 3M encourages managers to experiment, to take risks, to try
out new ideas, and not be afraid of failure. Within 3M, there is an expectation that managers will spend around
ten per cent of their time on projects of their own choosing. These projects are subject to the scrutiny of their
peers which provides constructive feedback. Even when an idea seems to fail, there is latitude for employees
to enlist the support of like-minded managers (or product champions) in an attempt to foster creativity and a
breakthrough. The product champion can be thought of as a change agent, someone who takes responsibility
for ensuring that change takes place. Without such a culture, the world may never have had Post-It Notes. Its
inventor, Art Fry, had been working on developing a strong adhesive for 3M, but failed to achieve this. What he
did develop was a weak adhesive, which allows paper to be stuck down, but also easily removed. This resulted
in the creation of Post-It Notes.
In subsequent research Jim Collins seeks to answer the question: what turns a company from being ‘good’ into being
‘great’? Or, put another way, what strategic change occurs within organizations that allows them to leap from being
good to being great?38 To do this, Collins and his research team identified organizations that had fifteen-year cumulative stock returns at or below the stock market. The companies then experienced a transition point, before going on
to achieve cumulative returns at least three times the market over the next fifteen years. The timescale of fifteen years
allows the research to filter out those spectacular companies that achieve great results, but which cannot sustain
them. The choice of returns three times the stock market means that such companies would have to beat the returns
achieved by recognized great companies such as Coca-Cola Motorola, and Intel.
9
The research team identified eleven companies which met their criteria for great organizations.39 For comparison they
made use of companies that were in the same industry and which had the same opportunities and similar resources at
the time of transition, but did not make the transition from good to great, and companies that temporarily went from
good to great, but were unable to sustain their performance. A key finding for companies that make the transition from
good to great is their use of the hedgehog concept.
The hedgehog concept is drawn from Isaiah Berlin’s story, ‘The Hedgehog and the Fox’. In this story, the hedgehog and
the fox are adversaries. The fox is very clever and knows many things. In contrast, the hedgehog knows only one big
thing. In their duels, the hedgehog always rolls up into a spiky ball and therefore always beats the fox. Collins draws an
analogy between the hedgehog and the leaders of good to great companies. Like the hedgehog, these leaders know
and pursue one thing. Their rivals, meanwhile, are trying many different approaches to match the complexity of their
world, while the hedgehog-like leaders construct the world into a simple unifying concept, as shown in Collins’s book,
Good to Great, and reproduced here as Figure 9.9.
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What you are deeply
passionate about
What you can
be the best in
the world at
What drives
your economic
engine
Figure 9.9 Three circles of the hedgehog concept. Source: Jim Collins, Good to Great, 2001. Copyright © 2001 by Jim Collins. Reprinted with permission.
According to Collins, a route to greatness is defined by an understanding of three issues.
1) ‘What you can be the best in the world at’. Collins sees this as going beyond the resource-based view
of core competencies, arguing that possessing a core competence does not mean you are the best in
the world at it. One might argue that this depends on how you define core competence, since for many
organizations their core competence does make them the best in the world at what they do (e.g. Toyota’s
production system).
2) ‘What drives your economic engine’. This helps managers to understand the single performance measurement that has the greatest impact on their business. For instance, for First Direct it might be overall customer
satisfaction.
9
3) ‘What you are deeply passionate about’. What is it that makes you passionate about the business you are in?
The good to great companies developed their strategies based on an understanding of these three issues. This understanding was then translated into a simple concept—a hedgehog concept. The point for leaders is not to try to be the
best, but to understand where you can be the best. We will review leadership in Chapter 10.
Summary
The chapter started with a discussion of the trade-off between specialization and coordination and the impact of this on
organizational structures. We evaluated the simple functional and divisional structures before moving on to more complex
matrix and network structures. We discussed Ghoshal and Bartlett’s argument for a focus on organizational processes and
a more integrative approach. This approach goes beyond the limitations inherent in merely making structural changes.
Goold and Quinn provided three reasons for establishing a strategic control system. They produce a contingency
framework highlighting different conditions when strategic control systems might be useful for an organization. We
assessed strategic change reviewing Greiner’s model, which highlights the challenges facing managers of growing
CHAPTER 9 Organizational Structures and Strategic Change
265
organizations. We also addressed integrative change by showing that change needs be part of a coherent and stable
system that recognizes the role of complements. Strategic drift was discussed, showing that managers need to surface
assumptions inherent in their organizational paradigm to facilitate change. We ended the chapter with a discussion of
visionary organizations and the use of BHAGs to guide their onward progress, before looking at how so-called ‘great’
companies deal with strategic change.
In Chapter 10, we discuss the role of leadership and assess its impact on strategic change.
W. L. Gore is a high-tech manufacturing company best known for its waterproof Gore-Tex
fabric. However, it’s diverse portfolio of products
include guitar strings, dental floss, acoustic vents
for mobile phones, and medical devices to treat
heart defects. The privately owned company has
a $3 billion turnover and employs more than
10,000 people worldwide. These employees,
referred to as associates, are part owners of the
company through its share plan. Gore prefers this
private ownership and believes this reinforces a
key element of its culture to ‘take a long-term
view’ when assessing business situations. It has Gore-Tex is a waterproof, breathable fabric membrane regularly used
in camping and sporting equipment and clothing. Source: © Cineberg/
offices in more than twenty-five countries, with Shutterstock.com
manufacturing operations in the US, Germany,
the UK, China, and Japan.
The company has made a profit every year since its incorporation. It has been granted more than 2,000 patents worldwide in a wide range of fields, including electronics, medical devices and polymer processing.
Company History
W. L. Gore & Associates was founded on 1 January 1958, in Newark, Delaware, by Wilbert L. (Bill) and
Genevieve (Vieve) Gore in the basement of their home. In 1969, Bill and Vieve’s son, Bob Gore, discovered
a remarkably versatile new polymer expanded polytetrafluoroethylene (or ePTFE). This led the company
into many new applications in the medical, fabric, aerospace, automotive, mobile electronics, music, and
semiconductor industries.
The founders’ vision was to build a firm that was truly innovative and move away from the traditional
ideas of management. As a result, you will find no rule books or bureaucratic processes. This is because Bill
Gore strongly believed that people come to work to do well and do the right thing. Instead of the reward
and control systems other companies rely on, Gore uses trust, peer pressure, and the desire to invent
great products. Instead of rigid hierarchies is a unique organization which draws upon the talents of every
associate.
9
CASE EXAMPLE W. L. Gore’s Unconventional Success
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9
Strategic Control Systems
At Gore, there are few employee titles; a major exception is CEO Terri Kelly. Managers are called leaders and
oversee teams and divisions. Any employee’s business card will simply have their name and the word Associate. This is irrespective of how much money they earn, how long they’ve been with the company, or their
responsibility. There are no organization charts, no budgets, and no strategic plans like most companies. What
Gore does is plan investment and forecast, but without the gamesmanship and inflexibility that comes with
traditional budgets. This is because Gore’s investments will reach fruition many years ahead and they are keen
to avoid short-term decision making, which is not in the best interests of the company. Therefore, the planning
and investment horizons have to match.
Gore is a big, established company which behaves like a small, entrepreneurial organization. One of the keys
to its success is the number of employees per plant. Bill Gore found that ‘things get clumsy when you reach 150
employees’. Therefore, plant size tends to be no larger than 50,000 square feet; which can accommodate no
more than 150 people. As Gore units grow in size, so they simply divide. These small plants are organized in clusters in close proximity with one another. The closeness encourages synergy and a sharing of ideas, while small
units encourage ownership and identity. This invariably creates a tension between potential diseconomies of
scale and the sharing of ideas through informal relationships.
CEO, Terri Kelly, has worked at Gore her entire life, after graduating from the University of Delaware with a
degree in mechanical engineering. Kelly worked as a product specialist before managing the global fabrics
division. She became CEO in 2005, after working for the company for twenty-two years; the fourth CEO in the
company’s history. Unlike other CEOs, Kelly was not appointed by a board, but as a result of nominations from a
wide range of associates. Leadership opportunities at Gore derive from the ‘following’ an associate has among
co-workers. Similarly, peer assessment is used to determine compensation.
The lack of business qualifications and formal business training has been no impediment to the CEO’s success. In many respects, her insider understanding of Gore’s unique culture allows her to continue the ‘Gore’ way
of doing things in a manner an outsider a simply could not.
Without doubt, another reason for Gore’s success is its unique culture. Gore doesn’t utilize traditional strategic control systems, such as control and rewards to guide behaviour. This is because in small groups, informal
relationships are more effective. The use of peer pressure is far more effective than a manager scrutinizing your
work. As a result, people strive to achieve what is expected of them. For example, in a Gore plant every part of
the process of designing, manufacturing, and marketing becomes subject to this same group scrutiny. In manufacturing firms with larger units, and considerably more people per unit, this kind of functional interrelationship
and understanding cannot be achieved.
In effect, everyone at Gore shares a common relationship and unity of purpose. The writer, Malcolm Gladwell, refers to this relationship as ‘transactive memory’. The term was coined by psychologist, Daniel Wegner.
It doesn’t just refer to ideas and facts stored in our heads; it refers to information we store with other people.
Two groups of people were tested with the same statements; one group comprising couples who knew each
other, another group comprising couples who did not know each other. The pairs who knew each other
remembered more statements than those who did not know each other. Wegner called this a transactive
memory system.
What has developed at Gore is a highly effective institutional transactive memory. Every associate in a unit
knows other associates well enough to know what they know. And they know them well enough that they can
trust them to know their role. At an organizational level, what Gore has achieved with its idiosyncratic culture
CHAPTER 9 Organizational Structures and Strategic Change
267
is the same kind of understanding, knowing, intimacy, and trust that exists within a family. This allows Gore to
innovate and rapidly respond to its consumer needs. Knowledge and expertise which resides in one part of the
company rapidly disseminates to all parts of the company. This makes for very efficient problem-solving, diffusion of ideas, and speed of execution.
In order to connect with younger associates, Gore has partnered with a Silicon Valley-based company called Institute for the Future. The objective is to utilize technology to help teams move faster and communicate. As with most
things at Gore, this approach is careful, incremental, and cautious, benefiting from the approach adopted by the
founders.
Questions
1. What is the role of culture in helping W. L. Gore to compete successfully?
2. In the absence of overt strategic control systems, how is the behaviour of Gore’s associates motivated and
guided?
Sources:‘At W. L. Gore, 57 years of authentic culture’, Fortune, 5 March 2015;‘Gore-Tex gets made without managers’, The Observer, 2 November 2008; M. Gladwell,
‘The Tipping Point’, Abacus, 2000; https://www.gore.com.
Review Questions
1. Examine the relationship between an organization’s structure and its performance.
2. Evaluate the role of strategic control systems in helping organizations to achieve and measure strategic
objectives.
Discussion Question
Research Topic
Consider organizations which change their structure as their strategy changes and those which change their
strategy as their organizational structure changes. On the whole, does the evidence support or refute ­Chandler’s
famous dictum that structure follows strategy?
Recommended Reading
For perspectives on the debate between strategy and structure see:
●
T. L. Amburgey and T. Dacin, ‘As the left foot follows the right? The dynamics of strategic and structural
change’, Academy of Management Journal, vol. 37, no. 6 (1994), pp. 1427–52.
9
Without a vision, an organization will fail. Discuss.
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●
H. Mintzberg, ‘The design school: reconsidering the basic premises of strategic management’, Strategic
Management Journal, vol. 11, no. 3 (1990), pp. 171–95.
For a discussion of how organizations grow and evolve, see:
●
L. E. Greiner, ‘Evolution and revolution as organizations grow’, Harvard Business Review, vol. 50, no. 4 (1972),
pp. 37–46.
For a discussion of strategic control systems and the disadvantages of focusing merely on organizational
structure, see:
●
●
M. Goold and J. J. Quinn, ‘The paradox of strategic controls’, Strategic Management Journal, vol. 11, no. 1
(1990), pp. 43–57.
S. Ghoshal and C. A. Bartlett, ‘Changing the role of top management: beyond structure to processes’,
Harvard Business Review, vol. 73, no. 1 (1995), pp. 86–96.
For an insightful discussion of visionary organizations, see:
●
J. C. Collins and J. I. Porras, Built to Last: Successful Habit of Visionary Companies, Random House, 1994.
www.oup.com/uk/henry3e/
Visit the online resources that accompany this book for activities and more information on organizational
structure and strategic change.
References and Notes
H. Mintzberg, Structures in Fives: Designing Effective Organizations, Prentice Hall, 1993.
2
A. Smith, The Wealth of Nations, originally published in 1776.
3
A. Chandler, Strategy and Structure: Chapters in the History of the American Industrial Enterprise, MIT
Press, 1962.
4
T. L. Amburgey and T. Dacin, ‘As the left foot follows the right? The dynamics of strategic and structural
change’, Academy of Management Journal, vol. 37, no. 6 (1994), pp. 1427–52.
5
Amburgey and Dacin, n. 4, p. 1446.
6
C. A. Bartlett and S. Ghoshal, ‘Matrix management: not a structure, a frame of mind’, Harvard Business
Review, vol. 68, no. 4 (1990), pp. 138–45.
7
Bartlett and Ghoshal, n. 6, p. 140.
8
M. Goold and A. Campbell, ‘Do you have a well designed organization?’, Harvard Business Review, vol. 80,
no. 3 (2002), pp. 117–24.
9
S. Ghoshal and C. A. Bartlett, ‘Changing the role of top management: beyond structure to processes’,
Harvard Business Review, vol. 73, no. 1 (1995), pp. 86–96.
10
R. S. Kaplan and D. P. Norton, ‘Using the balanced scorecard as a strategic management system’, Harvard
Business Review, vol. 74, no. 1 (1996), pp. 75–85; R. S. Kaplan and D. P. Norton, The Balanced Scorecard,
Harvard Business School Press, 1996.
9
1
11
M. Goold and J. J. Quinn, ‘The paradox of strategic controls’, Strategic Management Journal, vol. 11, no. 1
(1990), pp. 43–57.
12
H. Mintzberg and J. A. Waters, ‘Of strategies: deliberate and emergent’, Strategic Management Journal,
vol. 6, no. 3 (1985), pp. 257–72.
13
Kaplan and Norton, ‘Using the balanced scorecard as a strategic management system’, n. 10; Kaplan and
Norton, The Balanced Scorecard, n. 10.
14
W. G. Ouchi, ‘Markets, bureaucracies, and clans’, Administrative Science Quarterly, vol. 25, no. 1 (1980),
pp. 129–42.
15
Goold and Quinn, n. 11, p. 54.
16
C. Argyris, ‘Double-loop learning in organizations’, Harvard Business Review, vol. 55, no. 5 (1977),
pp. 15–25.
17
J. Lee and D. Miller, ‘People matter: commitment to employees, strategy and performance in Korean
firms’, Strategic Management Journal, vol. 20, no. 6 (1999), pp. 579–93.
18
Ouchi, n. 14.
19
L. E. Greiner, ‘Evolution and revolution as organizations grow’, Harvard Business Review, vol. 50, no. 4
(1972), pp. 37–46.
20
Greiner, n. 19, p. 38.
21
Greiner, n. 19, p. 38.
22
Greiner, n. 19, p. 40.
23
Greiner, n. 19, pp. 55–63.
24
Greiner, n. 19, pp. 55–63.
25
M. Hammer, ‘Reengineering work: don’t automate, obliterate’, Harvard Business Review, vol. 68, no. 4
(1990), pp. 104–11.
26
Hammer, n. 25, pp. 104–5.
27
E. Brynjolfsson, A. A. Renshaw, and M. van Alstyne, ‘The matrix of change’, Sloan Management Review,
vol. 38, no. 2 (1997), pp. 37–54.
28
P. Milgrom and J. Roberts, ‘Complementarities and fit: strategy, structure, and organizational change in
manufacturing’, Journal of Accounting and Economics, vol. 19, no. 2 (1993), pp. 179–208.
29
G. Johnson, ‘Managing strategic change—strategy, culture and action’, Long-range Planning, vol. 25, no. 1
(1992), pp. 28–56.
30
P. F. Drucker, Managing in a Time of Great Change, Butterworth Heinemann, 1995.
31
G. Johnson, G.S.Yip, and M. Hensmans, ‘Achieving successful strategic transformation’, MIT Sloan
Management Review, vol. 53, no. 3 (2012), pp. 25–32.
32
J. C. Collins and J. I. Porras, Built to Last: Successful Habit of Visionary Companies, Harper, 1994.
33
The eighteen visionary companies identified by Collins and Porras were 3M, American Express, Boeing,
Citicorp, Ford, General Electric, Hewlett-Packard, IBM, Johnson & Johnson, Marriott, Merck, Motorola,
Nordstrom, Philip Morris, Procter & Gamble, Sony, Wal-Mart, and Walt Disney.
34
Collins and Porras, n. 32.
269
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35
G. Hamel and C. K. Prahalad, ‘Strategic intent’, Harvard Business Review, vol. 67, no. 3 (1989), pp. 63–76.
36
E. H. Schein, ‘Coming to a new awareness of organizational culture’, Sloan Management Review, vol. 25, no.
2 (1984), pp. 3–16.
37
W. G. Ouchi, Theory Z: How American Businesses Can Meet the Japanese Challenge, Addison-Wesley, 1981.
38
J. C. Collins, Good to Great, Random House, 2001.
39
The eleven ‘good to great’ companies were Abbott, Circuit City, Fannie Mae, Gillette, Kimberly-Clark,
Kroger, Nucor, Philip Morris, Pitney Bowes, Walgreen’s, and Wells Fargo; see Collins, n. 38, p. 8 for a list of
comparison companies.
CHAPTER 10
STRATEGIC LEADERSHIP
10.1 Leadership
and Management
10.2 The
Learning Organization
10.3 Emotional Intelligence
and Leadership Performance
Main Reference Goleman,
D. (1998).
What makes a leader?
Harvard Business Review,
76(6), 93–102.
10.4 Narcissistic
Leaders and Leadership
Capabilities
10.5 The Impact of
Leadership on Values
and Culture
Extension Material
Narcissistic leaders
and their importance
Extension Material
Impact of culture
on organizations
10.6 Leading
Strategic Change
Extension Material
Difficulties faced
when implementing
strategic change
Learning Objectives
After completing this chapter you should be able to:
●
●
●
●
●
Define leadership and explain how it differs from management
Discuss the role of leaders in creating a learning organization
Explain the importance of emotional intelligence on effective leadership
Identify the benefits and dangers of narcissistic leaders
Discuss the role of leaders in relation to values and culture
Evaluate the leadership skills necessary for strategic change
10
●
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Introduction
A key factor in effective strategy implementation is the quality of strategic leadership. The ability of leaders to communicate organizational goals clearly and guide employees to focus their attention on achieving these goals is crucial to
success. This leadership ability is equally relevant in public, private, and not-for-profit sectors. This is not to imply that
individuals lower down in the organization cannot exercise a leadership role. Rather, it is to recognize that without
effective leadership at the top of the organization, individuals throughout the organization will be less likely to be
empowered and, therefore, less likely to develop their own leadership skills.
The best formulated strategy in the world will fail if it is poorly implemented. Although the leader of an organization
is ultimately responsible for a strategy’s success or failure, their role should be to encourage and create an organizational culture that empowers individuals to respond to opportunities. We saw in Chapter 9 how appropriate reward
and control mechanisms help to guide employee behaviour and signpost the important goals of the organization.
Systems, structures, procedures, and policies may aid the implementation of a strategy, but ultimately it is individuals
who implement strategy. Therefore, it is individuals and groups, within and outside the organization, who must accept
the rationale for strategic change.
In this chapter, we address the role that leadership plays in strategy implementation. The chapter begins with a discussion of the differences between leadership and management. We discuss the role of leaders in creating a learning
organization. We evaluate the impact of emotional intelligence on effective leaders and the links between emotional
intelligence and company performance. We assess the advantages and the dangers of narcissistic leaders, noting that
this personality type may actually be beneficial in dynamic markets. We discuss the role of leaders in shaping the
values of an organization to guide employee behaviour. The effects of national culture on individuals’ beliefs and
behaviour will also be identified, and the importance of culture on different leadership styles. Given the complexity
and uncertainty that surrounds most organizations, we identify some of the leadership skills necessary to achieve
strategic change.
10
10.1 Leadership and Management
A great deal of early work on leadership was taken up with discussions on nature and nurture. That is, are leaders born
or can leadership abilities be learned? We will eschew this debate and focus instead on the role of leaders in helping
organizations develop a competitive advantage. We might start by addressing the question: what is leadership and
how does it differ from management? We should make it clear that some scholars in the field of strategic management
use the term ‘management’ when it might be more appropriate to refer to ‘leadership’. Therefore, readers should be
mindful of this as they work through the chapter.
Peter Northouse defines leadership as, ‘a process whereby an individual influences a group of individuals to achieve a
common goal’.1 This view of leadership is made up of the following components: (a) process; (b) influence; (c) groups;
and (d) common goals. By defining leadership as a process this avoids issues of specific traits or characteristics that
reside in the leader. Instead, leadership is seen as a transactional event that occurs between the leader and the followers. It is about the mutual interaction between a leader and followers. By defining leadership as part of a process
Northouse democratizes it, making it available to everyone.
CHAPTER 10 Strategic Leadership
273
Leadership is also about influence which describes how the leader affects the behaviour of followers. Influence is the
fundamental characteristic of leadership. Since without the ability to influence followers there can be no leadership.2
Groups are important for leadership because, in most instances, a leader will influence a group to achieve common
goals. A group may take many forms such as a community group, an orchestra, or an organization. As before, without
groups to lead there can be no leadership.
A fourth component of leadership is common goals. A common goal implies that leaders and followers share a mutual
interest. The pursuit of common goals provides leadership with an ethical dimensional because it emphasizes the
need for leaders to work with followers to achieve mutual goals. Leaders and followers are mutually co-dependent;
they need each other. However, it is usually the leader who initiates and maintains the relationship. That said, we are
moving away from the leader as ‘the great man’ and instead, understand leaders and followers in relation to each other.
The leader is neither above nor superior to the followers.
In distinguishing between leadership and management John Kotter argues that management is all about coping
with complexity, whereas leadership is about dealing with change.3 The complexity arises out of the proliferation of
large corporations that occurred in the twentieth century. In order to operate effectively within these corporations
managers use a range of practices and procedures (see Chapter 9 for a discussion of strategic control systems).
According to Kotter, a key function of management which helps it to deal with complexity is planning and budgeting. The setting of targets or goals for the next quarter or year, designing detailed steps for achieving those goals,
and allocating resources as they are needed. The purpose of planning then is to produce orderly results, not change.
Richard Rumelt argues an important function of leadership is to absorb the complexity and ambiguity individuals
encounter as they try to solve organizational problems.5 All organizations face some situations which are characterized by
complexity and ambiguity. The leader’s role is to reframe an ambiguous and complex problem into a simpler problem that
can be passed to managers to solve. For Rumelt, the reason many leaders fail is because they promote ambitious goals,
but without resolving the ambiguity around specific obstacles that need to be overcome. Leadership is more than a willingness to accept the blame when something goes wrong. It is about setting proximate objectives and providing managers with problems that can be solved. A proximate objective refers to a goal that is close enough at hand to be feasible.6
In contrast with Collins and Porras, Rumelt argues for proximate goals. The example Collins and Porras provide of a
BHAG, Rumelt contends, was actually a carefully chosen proximate goal and readily achievable. Furthermore, when
10
In contrast, leadership is concerned with setting the direction for organizational change. It is about producing a
vision and developing strategies to realize that vision. The vision does not need to be overly complex or innovative; in fact, it should be clear and readily understood by all within the organization. In their research into visionary
organization, Jim Collins and Jerry Porras found that successful organizations use BHAGs—big hairy audacious
goals—to motivate and inspire individuals, thereby creating a unifying focal point of effort.4 They use the example
of President Kennedy’s challenge for the US to safely land a man on the moon. BHAGs also have the benefit of
providing continued momentum within an organization after the leader has gone (see Section 9.4.3, ‘Visionary
Organizations’). A key point for any vision is how well it serves the organization’s stakeholders and how easy it is
to translate into a competitive strategy. The planning of management and the direction setting of leadership works
best when they are used to complement rather than substitute for each other. That is, a vision can be used to guide
the planning process by providing a direction for its efforts and placing boundaries on its activities.
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faced with a dynamic environment it is illogical to suggest that a leader must look further ahead. This is because the
more dynamic the environment the less able a leader can perceive what is actually going on. Michael Porter argues
that the leader’s role is to develop strategy and to make the choices and trade-offs within the organization clear. This
need to make choices reflects the fact that not all activities an individual may pursue will fit with the organization’s
strategy. Trade-offs occur when activities are incompatible, implying that more of one activity means less of another. In
addition, the leader’s role is to teach managers about strategy and help them to acquire the discipline to make choices
in their day-to-day activities.7
In modern organizations, as we saw in Chapter 9, organizational systems are interdependent. These include such
things as structure, reward and control mechanisms, and processes. Therefore, trying to adjust one part of the system
in isolation can have no effect, or worse, a negative effect on the organization.8 The role of management is to develop
coherent systems which will allow plans to be efficiently implemented. This means communicating plans to individuals within the organization, making sure that the right people are in place to carry it forward, and providing appropriate incentives. As part of this organizing function, management must also have systems in place to monitor the
outcomes of human action. This allows corrective action to be taken to ensure that plans are properly implemented.
10
The respective leadership role is one of aligning. The aim is to get key stakeholders inside and outside the organization
to move in the same direction. Alignment can be thought of as an orchestral ensemble which includes everyone who
can help implement the leader’s vision or who may be able to impede it. Members of the organization, shareholders,
suppliers, customers, and regulatory bodies are a few of the cast members who might need to be aligned if change is
to occur successfully. It includes communicating the vision clearly, as well as getting individuals to accept the vision.
The trust and integrity of the leader are paramount here, as is the perception that a leader’s actions reflect his words.
This helps to empower people in the organization as they can use their initiative to take decisions that reflect the communicated vision without fear of reprisals. A relatively new field of research into leadership is authentic leadership.
Authentic leaders have a clear understanding of their own values and behave towards others based on these values.
When tested by difficult situations, rather than compromising their values, authentic leaders use those situations to
strengthen their values.9 Johnson & Johnson’s handling of the Tylenol scandal is an example of authentic leadership.
Management is also about controlling and problem-solving. The purpose of control mechanisms is to ensure that people’s behaviour conforms to the needs of the plan and that any variance can be quickly identified and corrected. This
means that management is about pushing people in a given direction. As Kotter states, the whole purpose of systems
and structures is to help normal people who behave in normal ways to complete routine jobs successfully, day after
day. It’s not exciting or glamorous. But that’s management.10
In contrast, leadership is about change, and change requires an adjustment in people’s behaviour. Unlike the control
mechanisms of management, leadership motivates by satisfying our human needs for achievement, recognition, and a
sense of belonging. An effective and authentic leader will ensure that the organization’s vision is in line with its employees’ own value system. As such, employees will derive intrinsic satisfaction from working towards its achievement. This
satisfaction is likely to increase where individuals are also actively involved in discussions of how the vision can be
achieved and are rewarded for their efforts. Table 10.1 provides a summary of leadership and management activities.
Where management involves dealing with organizational complexity, leadership involves dealing with change. Such
change includes the deregulation of markets, faster technological change, and shifting social trends. The role of leadership is to create a shared vision of where the organization is trying to get to, and to formulate strategies to bring
about the changes needed to achieve the vision. Effective leaders encourage leadership throughout the organization
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Table 10.1 Leadership and management activities.
Leadership Activities
Management Activities
Dealing with change
Coping with organizational complexity
Developing a vision and setting a direction for the organization
Planning and budgeting
Formulating strategy
Implementing strategy
Aligning stakeholders with the organization’s vision
Organizing and staffing to achieve strategy
Motivating and inspiring employees
Controlling behaviour and problem-solving to ensure strategy is
implemented
Recognizing and rewarding success
by empowering participants to make decisions without fear of reprisals. This dissemination of leadership allows organizations to deal effectively with increasing change in their competitive environments. A challenge is to blend the
distinct actions of leadership and management so that they complement each other within the organization.
There is general agreement that management and leadership involve different functions. Richard Cyert contends that
most people in leadership positions would be better characterized as managers rather than leaders.11 He argues that
leaders perform three broad functions: organizational; interpersonal; and decision making.
1. The organizational function requires the leader to try to get participants in the organization to behave in a way
that he or she feels is desirable. A leader can do this by influencing the process for setting goals in an organization. This is because what will be desirable for a leader will be the achievement of agreed goals, which in turn will
derive from the leader’s vision. According to Cyert, the leader’s role is to steer the organization by setting a vision
and being actively involved in the goal structure.
2. The interpersonal function requires the leader to ensure that the morale of participants is maintained.
This is more of an empathetic role, which requires the leader to be aware of the concerns of members of the
organization.
However, we should not forget that organizations are collections of individuals. Regardless of the strategies that are
put forward to achieve a vision, it is these individuals who will ultimately determine whether the strategy succeeds or
fails. The question then arises as to how leaders ensure that participants in an organization behave in a way that they
would like. Cyert claims leaders accomplish this by controlling the allocation of attention of members of an organization. The attention of individuals in an organization will be drawn to many different things. The leader’s role will be to
focus their attention on the achievement of the vision. Organizations operate in dynamic environments. Therefore, if a
vision is modified, the leader must ensure that participants’ attention, and therefore their behaviour, is also changed to
reflect these changing issues. In the same way a leader must ensure that all participants buy into a single goal structure
such that any goal conflicts between different parts of the organization are quickly resolved. This ensures that everyone in the organization is working towards the same outcome.
All leaders seek to improve the performance of their organization (see Strategy in Focus 10.1). A solution is
often thought to be a change in the organizational structure. However, as we have seen, the key point to bear in
mind is whether this change in structure will have an impact on the attention focus of participants. Any change in
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3. The decision function compels the leader to take decisions which allow the organization to achieve its goals.
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STRATEGY IN FOCUS 10.1 UK Chief Executives
Chief executives at British companies move on faster than in any country apart from Brazil, Russia or India,
according to a study of the world’s top 2,500 companies by PwC, the professional services firm. UK bosses are
spending 4.8 years in the top job, undershooting the five-year global average and falling way below the UK high
of 8.3 years in 2010. The median tenure has dropped for five of the past six years and is at its lowest level since
PwC began collecting the data on Britain’s biggest 300 companies in 2009.
The UK head of PwC’s strategy consulting business, said the brief leadership periods made it hard for
CEOs to have an impact. ‘Less than five years is a very short time to make real and tangible changes to a
business’, he said. ‘Stakeholders are demanding ever faster results but should consider the long term too, to
ensure stability.’ The turnover rate in the UK fell from 19.3 per cent in 2015 to 16.3 per cent. But more CEOs
were moving on than the global average, which stood at 14.9 per cent. Successions in the UK were planned
nine per cent of the time, while 3.3 per cent of CEOs were forced out and another four per cent changed in a
takeover.
The head of consulting at PwC UK, said CEOs face an ‘unforgiving’ business environment, fraught with social,
political, and technological upheavals. The study points out that CEOs are being held more accountable for their
actions. Despite these challenges, CEOs are relatively untested—more than three-quarters of newly appointed
UK CEOs last year had never led a public company before. Their average age was fifty-two, a year younger than
western European counterparts, but more sprightly than Japan’s sixty-one-year-old average.
Diversity was not notably boosted by top appointments in 2016. Just three of the forty-one new CEOs in the UK
companies studied were women, although that share was better than the previous year—up from 4.5 per cent
in 2015 to 7.3 per cent. Over the past half-decade, British companies have increasingly opted for British chiefs.
Only sixty-seven per cent of new CEOs were British nationals in 2012, compared to eighty-five per cent in 2016.
Of the new UK business leaders, fewer have experience of other countries—two-thirds had not worked in
other regions, which in 2012 was true of just half of the incoming top bosses. However, the proportion of stayat-homes was much higher in the US and Canada, where eighty-five per cent of new CEOs had not worked in
other regions, and Japan, where the figure was eighty-eight per cent.
Average time heading a company can seem short, but CEOs may be cheered to know that their staying power
compares favourably with professional football managers in the UK, whose average tenure is 1.23 years.
10
Source: Chloe Cornish, ‘UK chief executives spend less than five years in the job’, Financial Times, 15 May 2017. Used under licence from the Financial Times.
All Rights Reserved.
organizational structure should only be undertaken with a view to its impact on the attention focus of participants.
As Cyert states, ‘attention focus is central to the organizational function of leadership’. Similarly, if we look at the interpersonal function, the style adopted by a leader in his interaction with members of the organization is also important.
However, the issue is not one of whether the leader’s style is open or friendly per se, but rather whether the style allows
members to focus their attention on issues that the leader feels are important. The same is true for the third function of
leadership, the decision function. A leader takes decisions with a view to making the priorities for participants’ attention clear. In this way leadership decisions guide and modify individuals’ behaviour by focusing on the areas where
they want individuals to apply their attention. This presupposes that the leader possesses sufficient industry-specific
knowledge to allow him or her to identify and translate changes in their environment into the correct attention focus
for participants of the organization.
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10.2 The Learning Organization
It is said that the only sustainable competitive advantage is the speed and ability of an organization to learn.12 In the
past there were great leaders who ‘thought’ and ‘learned’ for the organization. These included Thomas J. Watson of IBM,
Alfred Sloan of General Motors, and the eponymous Henry Ford and Walt Disney. The role of everyone else within the
organization was assumed to be to carry out the leader’s vision and earn their approval. The problem with this is the
traditional hierarchical structures that ensure the command and control of individuals are not conducive to competing
in dynamic environments or for generating organizational learning.
The shift is away from the leader as a panacea and towards a solution that requires all levels of the organization to
participate actively. Peter Senge believes that ‘the old model, the top thinks and the local acts, must now give way to
integrating thinking and acting at all levels’.13 Senge sees the learning organization as comprising both adaptive and
generative learning. Adaptive learning is the ability to cope with changes in one’s environment, while generative learning is about creating change by being prepared to question the way we look at the world.
10
A transition from adaptive learning to generative learning can be seen in the total quality movement (TQM) in Japan.
Initially the focus was on making consumer products that were fit for purpose; that is, the product would perform
according to its specification. This evolved into understanding and reliably meeting customer needs. Now the focus
has shifted to creating what customers want, but may not have yet realized. This requires organizations to be prepared
to view the competitive environment differently. A major reason for the success of Japanese automobile companies
such as Toyota and Honda is their ability to view issues in manufacture in a systemic way. They adopt a way of thinking
that does not focus on one aspect of manufacture as the problem, but see any problem as part of an integrated system.
As a result, they avoid being stuck in a cycle of adaptive learning.
Henry Ford was the original founder of Ford Motor Company. Source: © aradaphotography/Shutterstock.com
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10.2.1 Building the Learning Organization
The leadership role in a learning organization is one of designer, teacher, and steward. These new roles require the
leader to develop a shared vision of where the organization wants to be. But also to make explicit and challenge the
assumptions on which decisions are made. In other words, to challenge the mental models of how we view the world
and to encourage a more systemic pattern of thinking. Senge asserts that the leader’s role is to help bring about
learning in the organization. This requires the leader to develop a vision of where the organization wants to be and to
juxtapose this with the current reality of where the organization actually is.
The difference between the two positions generates what Senge refers to as a ‘creative tension’. It is the leader’s role
to make explicit a vision of the organization which galvanizes people to want to create change. This is different from
problem-solving which seeks to get away from an undesirable current position. Creative tension uses the difference
between current reality and the vision to generate change, but it is not the undesirability of the current situation itself
that generates the creative tension. The disadvantage with an approach based on problem-solving is that as soon as
the problem is resolved or reduced, the momentum for change decelerates. With creative change, as we saw with
visionary companies in Chapter 9, the motivation for change is intrinsic, not extrinsic.
10.2.2 Leadership Roles
We can address the three distinct leadership roles that Senge identifies. These are the leader as designer, the leader as
teacher, and the leader as steward.
10
1. The leader as designer
The leader’s role as designer can be seen in the building of the core values and purpose of the organization.
This is the quiet behind the scenes work of leadership, which will have an enduring impact into the future. This
includes the credo of Johnson & Johnson that guided the behaviour of people in the company during the tampering with Tylenol in 1982 and 1989. It includes the decision of American pharmaceutical Merck to give away a drug
to cure river blindness which was guided by their core values. The other aspects of the leader as designer include
developing the strategies and structures that help to convert organizational values and purposes into business
decisions.
2. The leader as teacher
The leader as teacher requires leaders to assist individuals in the organization to be aware of their mental models
and the assumptions on which these are based. This allows managers to continually challenge their view of reality and overcome their cognitive bias. The intention is for managers to see beyond merely superficial issues and
discern the underlying causes of problems. Leaders in learning organizations influence individuals’ perceptions of
reality at three levels: events; patterns of behaviour; and systemic structure.
i) Events are primarily short term and often dramatic, for example an increase in interest rates as a result of a rise in
inflation.
ii) Patterns of behaviour view current events in the light of the historical changes which have an impact in bringing
them about. Here, managers would be focusing on extrapolation or trend analysis.
iii) It is only systemic structural explanations which deal with the underlying causes of behaviour.
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Therefore, the leader’s focus is predominately on systemic change. As we saw with Richard Cyert’s work on
leadership, if we want to engender change it is important to focus attention on what really matters. The
example the leader sets will be more likely to be replicated in the focused attention of organizational members. Therefore, it is crucial that a leader’s behaviour matches his rhetoric. In other words, the leader must be
authentic.
3. The leader as steward
The concerns of the leader as steward involve stewardship for all the people in the organization that the leader
directs. It also involves stewardship for the purpose and core values on which the organization is based. A leader
in a learning organization actively seeks to change how managers view their environment. The intention is to create a more successful organization with more satisfied workers than could be achieved in a traditional organization. For example, at W. L. Gore, the CEO doesn’t utilize traditional strategic control systems such as management
control and rewards to guide behaviour. Instead, informal relationships are allowed to develop as employees
work in small groups. The use of peer pressure has proven to be more effective than a manager scrutinizing your
work. As a result, people strive to achieve what is expected of them.
10.2.3 Leadership Skills
In conjunction with the leadership roles, there is a need for the development of new leadership skills. These leadership
skills need to be disseminated throughout the entire organization; they are not the preserve of a few key individuals.
They are building a shared vision, surfacing and testing mental models, and systems thinking.
2. Surfacing and testing mental models
If the leader is to attract new and innovative ideas, another leadership skill which needs to be disseminated
throughout the organization is surfacing and testing mental models. The leader needs to ensure that members
of an organization can differentiate between generalizations and the observable facts on which they are based.
In challenging our mental models, we need to be aware of when we are generalizing and when what we say is
actually based on fact.
3. Systems thinking
To engage in systems thinking leaders need to move beyond a blame culture. They need to discern the interrelationships between actions. They should recognize that small, well-focused actions can have magnified
results, if they occur in the right places.15 This is commonly referred to as a tipping point.16 A visionary leader
who deals only in events or patterns of behaviour will disseminate a reactive or responsive culture rather than a
generative one.
10
1. Building a shared vision
Creating a shared vision is an ongoing process, which involves the leader sharing his vision with members of the
organization to ensure that it accords with their own personal values. In this way, the shared vision is more likely
to be accepted by everyone. Effective leaders create a vision which allows them and others in the organization to
see clearly the steps to take to reach their goals. They might build on their present capabilities to work towards
the shared vision.14 It is recognizing that developing a vision is a continuous process.
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The US mobile phone company, Motorola, is a firm which one might consider is not a learning organization.17
Founded in 1928, it developed its own microprocessor in the 1970s, becoming the primary supplier to Apple. In
the 1980s Motorola was the world’s leading mobile phone supplier. In 1994, it achieved sixty per cent of the US
mobile phone market using its analogue technology. Around this time, digital technology, which could support
around ten times more subscribers than analogue for a given slice of radio spectrum, allowed companies to
spread fixed costs over a broader user base.
Motorola held several digital patents which it licensed to its competitors Nokia and Ericsson, but did not
utilize itself. It possessed the capability to make digital mobile phones and had data indicating the market
was demanding digital phones, but ignored this. If an organization is unwilling, yet perfectly capable, of
coping with change and satisfying consumer demand, this indicates a breakdown in leadership. By the time
Motorola launched its own digital mobile phone in 1997, the competition was already far ahead. Undoubtedly, one of the reasons this company failed to meet the challenge in the digital mobile phone market was
its strong corporate culture. It was known to focus on engineering first, and the market and its customers
second. In the past, its culture had brought the company great success. But it was Motorola’s strong culture
which was resistant to new ways of thinking and changes in behaviour. Somewhere along the way, Motorola
forgot to be ‘paranoid’, but relied instead on established ideas which defined their managerial thinking. The
top executive team was unable to disassociate themselves from their insular thinking of technology before
customer mind set.
Senge’s work, although widely disseminated, is not without its critics. Rumelt, in particular, is critical of the idea
of a shared vision as propagated by Senge. He argues that ascribing the success of companies like Ford and Apple
to a vision which is shared at all levels of the organization is a ‘distortion of history’.18 Rumelt contends a more
likely interpretation of Apple’s success is down to the outstanding technical competence of co-founder Steve
Wozniak and a certain amount of serendipity.
Furthermore, he argues that this type of thinking can lead to ‘template-style strategy’ in which you simply
fill in the blanks with vision, values, mission, and strategy, rather than undertaking the hard work of analysis.
The end result is a one size fits all. Rumelt’s concern is that these ‘New Age’ ideas, based on positive thinking,
should not replace the difficulty of choice, critical thinking, and coordinated action which is essential for
good strategy.
10
10.3 Emotional Intelligence and
Leadership Performance
A great deal of research has been undertaken to ascertain whether there are certain attributes or capabilities that can
distinguish effective leaders. Daniel Goleman undertook research into large global companies to determine the personal capabilities that drive outstanding performance.19 Goleman grouped capabilities into three categories:
(1) Purely technical skills, such as accounting and business planning
(2) Cognitive abilities, such as analytical reasoning
(3) Emotional intelligence, which manifests itself in an ability to work with others.
His findings suggest that an organization’s success is linked to the emotional intelligence of its leaders. Emotional
intelligence appeared to be the key ingredient for outstanding leaders; it was also linked to better performance in
organizations.
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The traditional attributes of leaders have usually included such factors as technical skills and IQ. Goleman does not
dismiss these attributes, but argues that they should be seen as threshold capabilities or entry-level requirements for
executive positions. They may be necessary for senior positions, but they are not sufficient criteria for effective performance in leaders. As Goleman states, ‘When I calculated the ratio of technical skills, IQ, and emotional intelligence as
ingredients of excellent performance, emotional intelligence proved to be twice as important as the others for jobs
at all levels.’20
This would suggest that effective leaders require more than an analytical mind or a stream of good ideas; they need
emotional intelligence. Goleman identified five components of emotional intelligence; the first three are personal and
the last two are social capabilities. They are: self-awareness; self-regulation; motivation; empathy; and social skills.
1. Self-awareness
Self-awareness is the first component of emotional intelligence. Individuals who possess a degree of
self-awareness are capable of speaking candidly about their own emotions and the impact of their emotions on
their work. Self-aware people can be recognized by their self-confidence. According to Goleman, they play to
their strengths, are aware of their limitations, and are not afraid to ask for help if it is needed. It is this emotional
capability of self-awareness that also allows these leaders to honestly assess the organization they work for.
3. Motivation
A trait found in almost all effective leaders is motivation—a desire to achieve for the sake of achievement. People
who are motivated will be passionate about their work and actively seek ways to improve what they are doing.
They constantly seek to measure their individual performance and that of their organization. They are committed
to their organization and will not be readily swayed to move jobs for mere financial gain. In seeking to stretch
themselves, such individuals will also be looking to improve their organization.
4. Empathy
Empathy implies that leaders will consciously consider employees’ feelings as well as other factors when they
are making decisions. For example, when leading a team, a leader must be capable of sensing and understanding the different points of view that each individual in the team holds. In a globalized economy, the need for
empathy is required to interpret accurately what people from different regions and cultures may be saying. For
example, being empathetic allows a leader to read accurately the body language of an individual, as well as
listening to their spoken words. Empathy is also important for leaders who wish to retain people with important
tacit knowledge.
10
2. Self-regulation
Self-regulation is a recognition that as human beings we are driven by our emotions, but we can also manage
them and channel them for productive purposes. Leaders who are in control of their feelings and emotions can
create an environment characterized by trust and fairness. Self-regulation is helpful in dealing with changes in
the environment. This is because a self-regulated individual can consciously listen to new ideas and approaches
rather than immediately reacting to what is being said. They are comfortable with change and ambiguity, and are
not easily panicked by a change in the competitive landscape. Goleman goes further and argues that self-regulation enhances integrity. In other words, the abuse of corporate power tends to occur where individuals have low
impulse control. We should perhaps be a little of wary of the argument that self-regulation enhances integrity.
In many instances, the self-regulation of one’s emotions derive more from a fear of the consequences or being
‘found out’ than integrity.
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5. Social skills
Whereas self-awareness, self-regulation, and motivation are emotional capabilities that we self-manage, empathy and social skills concern our capabilities for managing relationships with others. Social skills involve moving
people in a desired direction. Cyert refers to this as an organizational function of leadership; getting participants
in the organization to behave in a way that the leader feels is desirable.21 Social skills are the culmination of the
other emotional intelligence capabilities. In other words, leaders will be socially skilled when they have honesty
in evaluating their abilities, have mastered their own emotions, are motivated, and can empathize with others.
Therefore, social skills will manifest themselves through the working out of any of the previous four capabilities. It
is social skills that enable leaders to put their emotional intelligence to work.
Thus, the question arises: can emotional intelligence be learned? Goleman believes that it can, and furthermore that one’s emotional intelligence increases with age. That said, emotional intelligence is not automatic. It requires clearly directed effort and resources if individuals are to learn to enhance their emotional
intelligence. The pay-off is more effective leaders throughout the organization and improved company
performance.
10.4 Narcissistic Leaders and Leadership Capabilities
We have seen that leaders who possess emotional intelligence are more effective and capable of managing change
in organizations. In contrast with these leaders, Michael Maccoby identifies a different type of leader who is equally
effective in dealing with dynamic change, but also has the potential for creating destruction.22 Today’s leaders who are
transforming industries are different from their predecessors, and Maccoby attributes this to a change in their personality. Today’s leaders, he argues, exhibit a personality type which Freud termed narcissistic. Freud identified three main
personality types: erotic; obsessive; and narcissistic.
(1) Erotic personality types should not be confused with a sexual personality, but rather one for whom loving and
being loved are important. Typically, these are teachers, nurses, and social workers.
(2) Obsessive personalities are self-reliant and conscientious. They are always looking for ways to help people, listen
better, and find win–win situations.
10
(3) Narcissists are independent, aggressive, and innovative; they want to be admired.
Narcissistic leaders have always existed in the past and tend to emerge in times of political and social upheaval. As
business began to dominate the social agenda, so narcissistic leaders such as Henry Ford and John D. Rockefeller
emerged. The problem is that the very leaders who may be required for certain epochs can become obsessed with
their own grandiose ideas, emotionally isolated, and distrustful of alternative viewpoints. In many respects, a narcissistic leader represents the antithesis of a leader who possesses emotional intelligence. Thus, the key is to differentiate
between productive and unproductive narcissism.
Productive narcissistic leaders, such as Jack Welch of GE, are risk-takers who are capable of seeing the big picture.
They possess vision and an ability to communicate this vision through oratory. They have a desire to leave a legacy
behind. They are able to attract followers through their skilled oratory and charisma, and generate enthusiasm
throughout their organization, which helps galvanize change. However, narcissistic leaders need adulation and the
affirmation provided by their followers. And herein lies a danger—the very adulation that a narcissist demands
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brings self-assurance, but also allows him to ignore those who disagree with his views. Narcissistic leaders can
become destructive when they lack self-knowledge and restraint, and pursue unrealistic and grandiose dreams.
The weaknesses of a narcissistic leader can be seen as they become more successful. They are over-sensitive to criticism and become increasingly poor listeners. They cannot handle dissent and will tend to be hard on employees who
question their views. They do not want to change, and their success simply reinforces the need not to. For example, Jan
Carlzon, the former CEO of the Scandinavian airline SAS, originally turned around the airline’s fortunes and garnered
for himself much public adulation. In the 1990s he continued to expand the business with expensive acquisitions,
while paying too little attention to spiralling costs. As the organization expanded and losses increased, this brilliant
narcissist was eventually fired.
The disgraced CEO of the Royal Bank of Scotland, Fred Goodwin, was known to have a boundless capacity to grind
down his opponents. He insisted on RBS acquiring a second-hard car dealership, which was eventually sold back to the
original owners at a huge loss. He refused to listen to senior executives who queried why a global bank would want to
own a car dealership. He viewed the questioning of his decisions as dissent, which led to a culture of subdued discussions in the boardroom. Goodwin refused to take the advice of his mentor, the Deputy Group Chief Executive, who was
concerned with his treatment of subordinates.23 In 2008, the British taxpayer was forced to acquire a seventy-per-cent
ownership of the collapsed bank.24
A narcissistic leader can avoid potentially self-destructive behaviour by forming a close partnership with someone
he trusts. At Microsoft, Bill Gates was able to engage in blue-sky thinking because he had Steve Ballmer as chief
executive, to run the business. The problem was that both were seen as narcissistic (see Strategy in Focus 10.2).
Another approach is to indoctrinate the organization with your views. Jack Welch did this when he articulated his
views that GE become number one or two in its markets or exit them. Those who disagreed with Welch’s approach
and the culture it engendered did not last long in GE. The dilemma is that a dynamic environment characterized
by discontinuities needs narcissistic leaders. People like former Apple CEO, Steve Jobs, who possessed intellect,
vision, flair, and innovation, to shape the future. Another example would be Amazon’s Jeff Bezos. The challenge is
to get such luminaries to listen to, respect, and internalize the ideas that other members of the organization can
contribute.
10.4.1 Leadership Capabilities
We have seen that effective leadership is associated with emotional intelligence and a narcissistic personality,
particularly in dynamic markets. We might expect leaders who exhibit these qualities, especially emotional intelligence, to be equally effective in different industry environments. Boris Groysberg and his colleagues studied
twenty former GE executives who became chairman, CEO, or CEO designate at different companies between 1989
and 2001. Their choice of GE reflects its wide recognition as the premiere training ground for top executives. They
wanted to see if the skills these leaders possessed were portable; that is, does the fact that such leaders performed
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For a discussion of narcissistic leaders and their importance to organizations, visit the online
resources and see the Extension Material for this chapter.
www.oup.com/uk/henry3e/
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STRATEGY IN FOCUS 10.2 New Leadership at Microsoft
A decade ago, visiting Microsoft’s headquarters near Seattle
was like a trip into enemy territory. Executives would not so
much talk with visitors as fire words at them. If challenged on
the corporate message, their body language would betray
what they were thinking and what Bill Gates, the firm’s founder,
used often to say: ‘That’s the stupidest thing I’ve ever heard.’.
Today the mood at Microsoft’s campus is strikingly different.
Questions, however critical, are answered patiently. The firm’s
boss, Satya Nadella, strikes a different and gentler tone to Mr
Gates and Steve Ballmer, his immediate predecessor (although
he, too, has a highly competitive side).
The firm’s transformation did not begin with Mr Nadella.
It launched Azure and started to rewrite its software for the
cloud under Mr Ballmer. But Mr Nadella has given Microsoft a
new Gestalt, or personality, that investors appear to like. The
downgrading of Windows made it easier for Mr Nadella to
change the firm’s culture—which is so important, he believes
(along with Peter Drucker), that it ‘eats strategy for breakfast’.
Technologies come and go, he says, so ‘we need a culture that
Satya Nadella bucks the leadership trend at
allows you to constantly renew yourself’.
Microsoft. Source: © JStone/Shutterstock.com
Whereas Mr Ballmer was known for running across the stage
and yelling ‘I love this company’, Mr Nadella can often be seen sitting in the audience, listening. When, in 2016,
internet trolls manipulated Tay, one of Microsoft’s AI-powered online bots, into spewing racist comments,
people waited for heads to roll. Mr Nadella sent around an e-mail to say, ‘Keep pushing, and know that I am with
you . . . (the) key is to keep learning and improving.’
Employees are no longer assessed on a curve, with those ending up at the lower end often getting no bonus or
promotion. Sending such signals matters more than ever in the tech industry. Well-regarded firms find it easier
to recruit top-notch talent, which is highly mobile and has its pick of employers. A reputation for aggression
can attract the attention of regulators and lead to a public backlash, as Microsoft itself knows from experience.
10
Source: ‘What Satya Nadella did at Microsoft’, The Economist, 16 May 2017. Reproduced with permission.
well at GE mean that they could also perform as well at another organization?25 We might also infer that as these
executives were successful leaders at GE, they possessed a fair degree of emotional intelligence.
A massive seventeen of the twenty appointments all saw an increase in the market capitalization of the companies
they were moving to. This represents a belief by the stock market that such individuals possess skills that can easily
transfer to different settings. For instance, in 2000 when James McNerney and Robert Nardelli were passed over to
replace Jack Welch, they moved to 3M and Home Depot, respectively. The value of 3M and Home Depot increased
substantially. However, it is not perception, but leadership skills that deliver results.
Groysberg and his colleagues found that what is important is context, or the fit between the executives’ strategic skills
and the needs and the strategy of the organization. A given executive will possess general management skills such as
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the ability to develop a vision, motivate employees, and monitor performance. These skills are readily transferable to
new environments. Other management skills, such as knowledge of a particular company’s processes and management systems, do not transfer as well. Therefore, the reaction of the stock market was simply a signal that it believes
these General Electric executives had transferable general management skills.
Their research found that company-specific skills may also be valuable in a new job. Furthermore, they found that
other skills and experience which shape performance in one job can have an impact when transferred to a new job.
These skills include: strategic human capital, which manifests itself in an individual’s expertise in cost-cutting and
pursuing growth. Industry human capital, such as technical or regulatory knowledge of a specific industry. And relationship human capital, which comprises an executive’s effectiveness as a result of the relationships he or she develops
working as part of a team. The outcome of their research is that human capital can be thought of as part of a portfolio
of skills. At one end of the portfolio are skills likely to be portable, while at the other end are skills which are less portable. Thus, at one extreme we find general management human capital, which is highly portable. At the other extreme
is company-specific human capital, which is rarely portable. In between these two fall the three skills mentioned above;
that is, strategic, industry, and relationship human capital. Of these, the researchers found strategic human capital to be
the most portable and relationship human capital the least portable.
This research tells us that the companies that hired these twenty GE executives performed well relative to the stock
market, depending on whether there existed a good fit between the executives’ human capital and the needs of the
companies they went to. If not, they performed poorly against the market. Therefore, the more closely the match
between an executive’s new and old environment, the more likely it is that they will succeed in their new role. When
executives enter a new industry, their existing industry human capital will not transfer to the new industry. Their
company-specific skills will also not be relevant to a new job and will need to be unlearned.
What this research means for companies thinking of hiring such high-profile star executives is that where they come
from should not be the deciding factor in hiring them. The deciding factor should be an understanding of the portfolio
of human capital that each CEO candidate possesses. And whether their skills will transfer and meet the needs of
their new organization’s strategy and their new situation. This is particularly important when we remember that such
high-profile executives come at a premium.
We can address the role of leaders in relation to an organization’s shared values and its culture. We can also identify
the effect of national cultures on the beliefs and behaviour of individuals within organizations. An understanding of
national cultures and their impact on behaviour is particularly important for leaders of multinational corporations.
10.5.1 Leadership and Values
In looking at how executives spend their time, Tom Peters noted that although their time and attention are fragmented
this can work to their advantage.26 For example, when assessing work, top executives tend to be given a single option to
review rather than competing options. Their decision on this single option does not say anything about the proposal’s
optimality, but rather sends a clear signal back to organizational members as to whether the organization is moving in
the desired direction or not. Their input is a check on the vision of the organization. It also signals to middle managers,
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for example, what the next proposal should look like. If senior executives had more time, they would not be inclined
to fine-tune proposals, but would be engaged in a more fundamental overhaul. The downside to this fragmentation
of time is that the constant flow of information multiplies the opportunity for inconsistent signals to the organization.
Peters’s approach portrays top executives as coping with the reality of disorder and non-linear events. This resonates
with Henry Mintzberg’s approach to strategic management in which leaders craft strategy rather than deliberately
planning it.27 Amidst this relative chaos what leaders can do is shape their organization’s values and lead by example.
In this untidy world ‘the effective leader is primarily an expert in the promotion and protection of values’, and dealing
with ‘the shaping of values becomes pre-eminently the mission of the chief executive’.28 The leader’s role is to build
consensus throughout the organization. Their actions, over time, are part of a ‘guiding, directing and signalling process
that are necessary to shape values in the near chaos of day-to-day operations’.29 How a leader behaves is crucial for
sending the right signals to the rest of the organization.
10.5.2 Leadership and Culture
Geert Hofstede studied the culturally determined values of people in over fifty countries.30 They all worked in the local
subsidiaries of a large multinational corporation (IBM). The benefit of looking at people who work for a multinational
corporation is that they are similar in all respects except their nationality. Hofstede was initially able to devise a model
of culture based on four separate dimensions. A dimension is simply an aspect of culture which can be measured in
relation to other cultures. The four dimensions are (1) power distance; (2) collectivism versus individualism; (3) femininity versus masculinity; and (4) uncertainty avoidance. The model is a way of measuring differences between national
cultures. A country will attain a score on each of the dimensions according to its nearness to each dimension. Over
time a fifth dimension was identified: (5) long-term orientation to life. Interestingly, Hofstede attributes the fact that
this dimension was not identified before to the bias that exist in the minds of researchers studying culture. That is,
even researchers studying culture have their own mental models determined by their national cultural frames of
reference.
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Although the use of a dimension is not without its methodological limitations, it does have the benefit of allowing
clusters of countries with similar scores to emerge. We might also note that research into national cultures and their
dimensions provides only part of the picture of our understanding of corporate culture. We can evaluate each of the
five dimensions to determine, to some extent, their impact on organizational behaviour.
1. Power distance index (PDI)
Power distance is defined as the extent to which the less powerful members of institutions and organizations
within a country expect and accept that power is distributed unequally.31 What it shows us is the extent to which
employees in IBM’s subsidiary in one country answer the same questions differently from IBM employees in
another country. Or, put another way, it helps to explain the impact of national cultures on leadership styles.
The study showed a high power distance for Latin American countries such as Mexico and Guatemala, and for
India, France, and Hong Kong. Lower power distances exist in the UK, the US, and Scandinavian countries such as
Finland, Norway, and Sweden.
This informs us about dependence relationships in a country.
What it tells us is that, other things being equal, employees in high power distance countries have a
preference for leadership that involves an autocratic style. There is likely to be much more dependence
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of subordinate employees on their leaders. In contrast, employees in low power distance countries prefer
leadership that involves consultation and much less dependence on their leaders. This helps to explain why
certain Western leadership styles which bring success in the UK or US may flounder when used in Mexico, for
example.
3. Masculinity and femininity
This concerns the desirability of assertive behaviour against the desirability of modest behaviour; Hofstede refers to
the former as masculinity, and to the latter as femininity. Masculinity refers to societies in which gender roles are
clearly defined: men are expected to be assertive and tough. Femininity refers to societies in which gender roles
are less clearly defined: both men and women are expected to be modest and caring.
This was the only dimension in which male and female IBM employees scored consistently differently. It
shows that, among other things, men attach greater importance to earnings and job recognition, whereas
women attach more importance to good working relationships with their immediate supervisor and their
colleagues. The former is associated with masculine competitive roles, and the latter with more caring
­feminine roles.
Japan, Austria, and Venezuela scored highest as the most masculine countries, with clearly defined roles for
men and women, while Sweden, Norway, and the Netherlands scored highest as the most feminine countries.
Therefore, we can deduce that Japan’s masculine culture and work practices, which invariably translate into few
female management positions, would be difficult to implement in Scandinavian countries.
4. Uncertainty avoidance
Uncertainty avoidance is the extent to which people feel threatened by uncertain or unknown situations.
This manifests itself in the need for predictability, and clearly defined rules. Countries which experience high
uncertainty avoidance are seeking to reduce ambiguity. People from these countries are looking for structure and
stability. Greece, Portugal, and Guatemala scored highest on this index, with Belgium and Japan not far behind.
Denmark, Singapore, and Jamaica scored lowest on uncertainty avoidance, closely followed by the UK and the
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2. Individualism versus collectivism
Individualism refers to societies in which there are fewer ties between individuals and where everyone is
expected to look after themselves and their own immediate family. At the other end of the spectrum is collectivism; these are societies where people are integrated into strong cohesive groups, and the interests of the
individual are sub-ordinate to those of the group.
The extent to which countries scored as individualistic or collectivist was based on respondents’ answers to
questions about what they would consider as their ideal job. Individualistic employees believe that a job which
leaves quality personal time for family is important. In contrast, collectivist individuals saw training opportunities to improve learning as more important. The US, Australia, and the UK scored top on this index as the most
individualistic nations, and Guatemala, Ecuador, and Panama were the most collectivist. Individualism, such as
the pursuit of personal time, emphasizes the individual’s freedom from the organization. Training and development, in contrast, is something the organization does for the employees. The extent of a nation’s individualism
versus collectivism may also go some way to explaining why Japanese leadership practices seem to experience
difficulties when transposed verbatim to the US.
UK, US, and Australian organizations competing abroad need to remember that in collectivist societies, such
as Saudi Arabia, the personal relationship between individuals takes precedence over any task and needs to be
established first. This takes time and patience.
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US. We should be careful not to confuse uncertainty avoidance with risk avoidance. A country which experiences
high uncertainty avoidance is still able to take risks.
5. Long-term orientation
Nations with a long-term orientation value thrift, persistence, and hard work. In contrast, nations with a
short-term orientation tend to be less persistent and expect quick results. If we ‘map’ a long-term orientation for different countries, we find China, Hong Kong, Taiwan, and South Korea score highest in having a
long-term orientation, while Pakistan, Nigeria, and the Philippines scored lowest, followed by Canada, the
UK, and the US.
An understanding of national cultures is clearly important for leaders who manage multinational organizations. For example, when Ikea entered the US market, its executives were surprised at the number of
vases they were selling. Eventually, it dawned on staff that Americans were buying them not to put flowers
in, but to drink from. The glasses Ikea stocked were just too small for American tastes. The benefits of an
appreciation of national cultures, for instance by leaders involved in international mergers and take-overs,
should not be underestimated. An understanding of culture and its effect on employees’ behaviour will,
amongst other things, help leaders to develop appropriate reward and control systems. An appreciation of
cultures can also help leaders implement strategic change and avoid wasting resources through avoidable
cultural errors.
This said, the needs of the competitive environment may force counter-cultural changes. For example,
the Japanese investment bank Nomura bought the collapsed Lehman Brothers’ European, Middle Eastern,
and Asian businesses in order to expand internationally. The former Lehman traders working for Nomura
in Japan now face Nomura executives who are much more hands on than the executives in their former
firm. More importantly, Nomura expects that by hiring former Lehman employees this may help facilitate
a change in the corporate culture in its Japanese operation. For instance, Nomura now offers employees in
Japan the prospect of higher pay and bonuses in return for accepting that they can be fired more easily if
they fail to meet performance targets. This change links remuneration to personal and departmental performance, largely anathema to Japanese employees, rather than organizational performance, which has always
been the norm.
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For more information on the impact of culture on organizations, visit the online resources and see
the Extension Material for this chapter.
www.oup.com/uk/henry3e/
10.6 Leading Strategic Change
In Chapter 9 we looked in detail at how organizations can undertake strategic change. Here we will address the specific role of business leaders in directing strategic change. We will identify the relationship between the acceptance
of ideas for change and an organization’s existing culture. We will also look at the leadership skills necessary to implement change effectively and barriers that need to be overcome.
The values of an organization will inevitably manifest themselves in its core or dominant culture. The culture may
have existed for generations and will take time to change in a desired direction. Therefore, an organization’s culture is
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a powerful instrument for exhibiting or inhibiting change. Even good ideas that conflict with the existing culture may
be difficult to implement. William Schneider argues that good ideas will fail unless they are aligned with the organization’s business strategy, leadership, and dominant culture. Schneider suggests four reasons why good management
ideas may not be adopted within the organization.32
1. All organizations are living social organisms.
All organizations have their own idiosyncratic culture. They are communities of people and not machines,
although they may have some machine-like characteristics. All living systems grow and develop from the inside
out. They start from their core and develop outwards. We can draw a parallel between biological systems and
organizations. In the same way, people, organizations, and societies exist in relation to each other. They have their
unique patterns, which are non-linear, but their development occurs from the core to the periphery. The point is
that for any ideas to work they must be based on the non-linear nature of the organization.
2. Culture is more powerful than anything else in the organization.
An organization can have a brilliant strategy, but if it does not align with the organization’s culture it will inevitably fail. To succeed, any change must align with one of four different types of culture: control, collaboration, competence, and cultivation.33 Therefore, regardless of the validity of any given idea, it must also fit with the particular
type of culture prevalent in an organization if it is to succeed.
3. System-focused interventions work, while component-focused interventions do not.
We have seen in the previous chapter that a systems approach that emphasizes alignment between different
parts of the organization is more likely to succeed in implementing change. This is simply a recognition that one
size fits all does not apply.
4. Interventions that are clearly linked to an organization’s business strategy work.
It is strategy that adds value to an organization. Therefore, all management ideas have to be clearly aligned
with the organization’s strategy otherwise there is a danger of pushing the organization off course. It is the
alignment of new ideas with an organization’s value-creating strategy that is important in trying to instigate
change.
Transformational leadership is concerned with improving the performance of individuals and developing individuals
to their fullest extent.34 Transformational leaders tend to exert influence, which encourages individuals to accomplish
more than what is usually expected of them. They are often assumed to be effective at motivating individuals to work
towards some greater good. It is often associated with charismatic and visionary leadership. It can be usefully compared with transactional leadership. Transactional leaders exchange things of value to advance their own interests as
well as the interests of their followers; for example, a manager who promises an employee promotion if they meet a
certain sales target. In contrast, transformational leaders interact with others in a way that raises the level of motivation in both the leader and the individuals.
The paradox of strategic change is that all organizations compete in changing environments, but the individuals who
make up these organizations are resistant to change. Organizations face pressures for change from competitors, suppliers, and customers, as well as internally from poor leadership, high labour turnover, and other such factors. These
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factors will eventually begin to coalesce into an urgency to do something. However, it is often as the need for change
becomes increasingly apparent that employees’ resistance to change becomes greatest. If the nature of individuals is
to avoid change, then the first challenge for leaders is to manage employee resistance.
According to Manfred Kets de Vries this requires an effective change agent, ideally the CEO, who has power and authority to drive change initiatives.35 The change agent will be a visionary who combines charismatic qualities with an
architectural role. For example, in an effort to restore Sony to profitability its first non-Japanese chief executive, Sir
Howard Stringer, implemented an efficiency drive that closed twenty per cent of the consumer electronics company’s
manufacturing and shed 20,000 jobs. In an effort to gain a creative momentum he persuaded Sony’s engineers, amidst
much resistance, to embrace the networked era.36
Charismatic leaders can be effective change agents because they seek to change the status quo and are gifted at building alliances and making individuals feel valued. This is important because if people are inspired and empowered to
act they will produce greater efforts and take risks in pursuit of a shared vision. However, as we saw in Chapter 9, trust,
rewards, and communication are essential if individuals are to engage in change.37
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Kets de Vries interviewed two leaders who epitomize the ability to sustain change and innovation in their organization:
Richard Branson, of the Virgin Group, and Percy Barnevik, previously CEO of ABB. Both leaders combine charismatic
leadership with architectural skills to bring about change in their organizations. Richard Branson’s Virgin Group is
famous for taking on established industries. The Virgin Group’s core businesses include megastore retail outlets, hotels,
communications, and an airline. The company’s business maxim is similar to the credo of Johnson & Johnson. Where
Johnson & Johnson put customers first, Branson has staff first, customers second, and shareholders third. Branson
clearly believes that looking after his people comes first. It is this commitment to staff which helps facilitate change. In
addition to charismatic qualities, Richard Branson’s architectural skill allows him to design the Virgin Group’s structure
in a way which encourages a creative entrepreneurial atmosphere.
Do you consider Richard Branson a transformational leader? Source: © stocklight/Shutterstock.com
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His divested record company provides a blueprint. When his record company grew to around fifty employees, Branson
recalls that he went to see the deputy managing director, the deputy sales manager, and the deputy marketing manager, and said: ‘You are now the managing director, the sales manager, and the marketing manager’ and put them into
a new building, and ‘when that company got to a certain size, say 50 people, I would do the same thing again’.38 The
culture that Branson has created is one of speed of decision making, devoid of formal board meetings and committees.
He is accessible to anyone who wants to discuss an idea, but prefers that they just go ahead and do it. His passion is
for shaking things up, remoulding established industries. Indeed, his legacy to the Virgin Group will no doubt be this.
Another transformational leader is Percy Barnevik who merged ASEA, a Swedish engineering group, with Brown Boveri,
a Swiss competitor, to create ABB. ABB competes in global markets for electric power generation and transmission
equipment, robotics, and high-speed trains. Barnevik’s vision was one of exploiting the organization’s core competences
and global economies of scale while maintaining and encouraging a local market presence. Barnevik’s architecture
involved the introduction of a matrix structure which simultaneously allows managers around the globe to make decisions about product strategy without having to think about their impact on national markets. At the same time, national
companies within the group had the freedom to remain focused on their local markets. As Barnevik stated, ‘What I have
tried to do is recreate small company dynamism and creativity by building 5,000 profit centres. The advantages lie in
communication and feedback. An environment where you can have creative, entrepreneurial people.’39
Barnevik recognized that to get the best out of people requires more than architecture; it requires tapping into the
values of employees and aligning the organizational vision with those values. The vision needs to inspire people and
bring out the best in them. The mission statement should make people feel proud of what the organization is trying
to achieve. Importantly, the leader must be authentic and live up to the values he or she sets for the organization. Like
Branson, Barnevik was passionate about change, breaking into new industries, and galvanizing employees to break
new ground.
In directing change, both Branson and Barnevik motivate their employees to embrace the dynamic of change and
actively promote environments which mitigate resistance to change. Unlike the narcissistic leader, there is a confidence and security that employees can try ideas which have not emanated from the CEO. There is also a clear recognition that people need more than financial rewards and financial targets to motivate them. As Branson puts it, ‘I think
fun should be a motivator for all businesses.’
In contrast with Kets De Vries, Collins and Porras argue that a little too much is often made of the role of charismatic
leaders in shaping organizations. Their research (discussed in Chapter 9) suggests that charismatic leaders are not
of paramount importance in visionary companies.41 They cite organizations such as 3M, Procter & Gamble, Merck,
and Sony, who have at various times throughout their history had leaders who made significant changes, but were
not what might be understood as high-profile charismatic leaders. Instead, Collins and Porras argue for the setting
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The charismatic and architectural skill of Richard Branson and Percy Barnevik is not simply building organizational
structures, but creating an environment in which employees feel free to make decisions, take risks, and even fail. This
requires a focus on the customer as the driving force for change. A key success factor for the Virgin Group is its ability to move fast. As Branson says, ‘I can have an idea in the morning in the bath tub, and have it implemented in the
evening.’40 The need for strategic control systems or transactional leadership is reduced when employees internalize
shared corporate values. These values go beyond an increase in the bottom line—which fail to motivate anyone.
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of BHAGs that are independent of management style, thereby ensuring that the succession of a charismatic leader
becomes less of a problem.
10.6.2 Theory E and Theory O Leaders
Michael Beer and Nitin Nohria suggest two theories of change which are based on different assumptions about why
and how change should be made.42 These are Theory E and Theory O. A Theory E change strategy is based on achieving economic value for shareholders and is characterized by downsizing and restructuring. This type of change is
frequently found in the US, particularly in turnaround situations. Theory O adopts a softer approach which recognizes
that if change is to be constructive and endure, it must affect the corporate culture and the way in which employees
work. This type of theory is more likely to be found in European and Asian businesses. Both theories are useful for
organizations, both have their costs. The challenge is how to build competitive advantage while managing the inherent tensions between Theory E and Theory O.
To do this, leaders must engage in corporate transformations which do not simply institute Theory E and Theory O
strategies in sequence, that is, one after the other, but rather combine the two strategies in a more holistic manner.
Jack Welch used a sequenced approach to change. He started with a Theory E type strategy by setting a goal for managers to be the first or second in their industry, or else exit. It was only once the hard issues of widespread redundancies and restructuring had taken place that Welch turned his attention to organizational changes which affected the
culture within GE. The problem with sequencing is the time it takes; at GE the timescale was almost twenty years. Also,
unlike Welch, once a leader engages in a Theory E approach he loses the trust and confidence of employees, which is
necessary to change the corporate culture.
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Few employees would be willing to listen attentively to a CEO who wields a corporate axe in one instance, and then
wants to talk about trust and commitment. However, the research by Beer and Nohria suggests that it is possible to
increase economic value quickly while also nurturing a trusting corporate culture. This was done by the UK retailer
ASDA under the stewardship of Archie Norman and his deputy CEO, Allan Leighton. When Archie Norman took over
as CEO of ASDA, he and Allan Leighton successfully improved economic value and were widely credited with bringing
about a change in the behaviour and attitudes of employees. Similarly, when Archie Norman joined the British broadcaster, ITV, he encouraged everyone within the corporation to email him about his strategic review, appending his personal email address. At the same time, he was forensically dissecting the company to see where value could be added.
Beer and Nohria argue that all corporate transformations can be compared according to six dimensions of change.
These are goals, leadership, focus, process, reward system, and the use of consultants. Given the different assumptions
on which the two theories are based, they will manage change on these six dimensions differently. If we look at each
of these in turn, we can see how Norman and Leighton successfully combined the Theory E and Theory O approaches
to bring about effective change at ADSA.
1. Goals—confront the tension between Theory E and Theory O.
Archie Norman made it clear at the outset that he would be applying E and O strategies of change. He said, ‘Our
number one objective is to secure value for shareholders’, but went on to say that ‘I intend to spend the next few
weeks listening . . . we need a culture built around common ideas and goals that include listening, learning, and
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speed of response.’43 In effect, he was saying that without an increase in shareholder value, ASDA would fail to
exist over the long term. But also, that he wants all employees to participate and be emotionally committed to
improving ASDA’s performance.
2. Leadership—set the direction from the top and engage people below.
Although Norman was clearly the architect of ASDA’s strategy, he set up programmes such as ‘Tell Archie’ to
encourage employee participation. We saw earlier that a narcissistic leader can often benefit from having a
trusted significant other. The same is true for a leader pursuing a strategy of change that involves Theory E. Archie
Norman recognized the benefit of employing an opposing leadership style, hence the early recruitment of Allan
Leighton who adopted a more employee-focused approach which contrasted with Norman’s analytical style.
3. Focus—address the hard and soft sides of the organization at the same time.
Norman removed unproductive senior management layers and instigated a wage freeze which affected everyone in the organization—Theory E. At the same time, he was committed to making ASDA an enjoyable place to
work by removing hierarchies, and making it fairer and more transparent—Theory O.
4. Process—plan for spontaneity.
Stores managers were encouraged to experiment with their store layout, change employee roles, change the
product ranges, and generally use their initiative to make changes that they believed would benefit the consumer. ASDA set up some experimental stores to help develop a learning environment. The culture within these
experimental stores was ‘risk-free’; that is, no negative sanctions were applied for trying things that failed.
5. Reward system—incentives should reinforce change, not drive it.
ASDA has a share-ownership plan which covers all employees. Financial incentives, an E type incentive, were used
to reward employees who were already motivated and committed to change.
For examples of the difficulties faced by leaders when implementing strategic change in
organizations, visit the online resources and see the Extension Material for this chapter.
www.oup.com/uk/henry3e/
10.6.3 Leadership and Chaos
In a rational world in which events in the external environment are repetitive or subject to some form of knowable
pattern, strategic management as espoused so far has a key role to play. However, if the world is also non-rational
and periods of stability sit alongside periods of instability, then this may require leaders to adopt a different mental
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6. Use of consultants—as expert resources who empower employees.
Consultancy firms were used by ASDA, but their role was deliberately cut short by Norman to avoid building up
a dependency on their expertise. Consultants were used to reinforce what Norman and Leighton were already
planning to do.
ASDA is an example of an organization which successfully combined Theory E and Theory O change patterns.
This was achieved through its willingness to develop and change in the long term without sacrificing the need to
generate acceptable shareholder returns. ASDA was bought by Wal-Mart, and Archie Norman stepped down as
CEO, having accomplished the changes he set out to achieve.
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model when developing strategy. When we see an organization as part of a dynamic system we are concerned
with how it changes over time and the patterns of change that subsequently develop. We want to know whether
these patterns display properties that are stable or unstable, predictable or unpredictable.
Ralph Stacey defines chaos as an irregular pattern of behaviour generated by well-defined non-linear feedback rules
commonly found in nature and human society.44 As systems move away from their equilibrium state they are prone
to small changes in their environment which can cause major changes in the behaviour of the system itself. In the
business world, a leader may attach great importance to small differences in customer requirements and develop
hugely differentiated products. Under conditions of chaos the long-term future of an organization is assumed to be
unknowable. If leaders cannot know what the future holds, then chaos theory holds little place for long-term plans
and visions of future states.
However, this may be slightly overstating the case since the future may be unpredictable at a specific level, but at a
general level there are recognizable patterns. For example, no one can predict the shape of individual snowflakes as
they fall to the ground, but we can still recognize them as snowflakes. It is this ability to recognize patterns at a general
level that allows leaders to cope with chaos. Indeed, we might argue that this gift is much more highly developed in
some than in others. For example, although Bill Gates and Steve Jobs were unable to state specifics, they did correctly
envision that a time would come when we would all have computers in the home. It is these boundaries around instability that allow us to make sense of our world. The use of reasoning, intuition, and experience helps us to cope with
change and, therefore, chaos.
Chaos and Innovation
Stacey suggests eight steps to help leaders encourage innovation and create a new strategic direction.
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1. Develop new perspectives on the meaning of control.
Innovation may be more likely to come about if leaders allow self-organizing processes and learning groups to
develop. This means rethinking their traditional ideas about control of individuals’ behaviour and letting the
group itself exercise that function.
2. Design the use of power.
The group dynamic that is conducive to complex learning occurs when the leader’s power is used to create an
environment in which the assumptions that are the basis for decisions can be challenged, and there is open questioning of the status quo. In contrast, when power is wielded through force and authority, the group dynamic
will be one of submission, rebellion, or suspension of critical faculties. In these cases, complex learning among
individual members of the group will not take place.
3. Encourage self-organizing groups.
In common with networks, which we discussed in Chapter 9, a self-organizing group is free to make decisions
within the context of the boundaries of its work together. A self-organizing group works best if it is allowed
to form spontaneously and set its own aims and objectives. The output may conflict with the views of senior
management, but this is to be expected when ideas are allowed free reign. In 3M, managers are allowed time to
pursue their own ‘pet’ projects with other managers.
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4. Provoke multiple cultures.
This allows new perspectives to proliferate across the organization by moving people from different business
units and functions to create a more culturally diverse organization.
5. Present ambiguous challenges instead of clear long-term objectives or visions.
Top management can encourage individuals to think about new ways of doing things by giving them ambiguous challenges and partially developed issues to consider. This does conflict with Rumelt’s contention that the
leader’s role is to reduce ambiguity.45 Senior management should also be open to having their own ideas challenged by subordinates.
6. Expose the business to challenging situations.
Leaders should not be afraid to expose their organization to demanding situations. We saw in Chapter 9 how organizations in home markets which have the world’s most challenging customers and innovative competitors will learn
far more than other organizations, and therefore will be more likely to build a sustainable competitive advantage.46
7. Devote explicit attention to improving group learning skills.
Senior managers encourage new strategic directions to emerge when they allow the dominant mental models
that are held within the organization to be challenged. This is a prime role for leaders if learning is to take place.
8. Create resource slack.
New strategic directions and innovations in the organization will only occur when top management invests sufficient time, effort, and organizational resources.
Chaos theory, then, sees that a traditional planning approach to strategic management may benefit the
organization over the short term. Over time, however, the lack of a causal link between organizational actions
and outputs means that the role of leadership should be to shun visions and long-term plans. And create instead
an environment characterized by spontaneity and self-organization. Chaos theory does not make traditional
approaches to strategic management obsolete; rather, it places them in a much more constrained time horizon.
As we have seen in preceding chapters, the choice is seldom either/or, but more one of and.
We started the chapter with a discussion of the differences between management and leadership in order to distinguish their different roles. We noted that management is about coping with complexity, whereas leadership is about
dealing with change. We discussed the role of leaders in building a learning organization. We noted the importance
of allowing individuals to challenge mental models that exist within the organization if we desire complex learning
to take place. We assessed the impact of emotional intelligence on effective leadership and company performance.
We noted that emotional intelligence appears to be a better predictor of success for a leader than either IQ or technical skills.
The benefits and dangers of narcissistic leaders were evaluated and suggestions put forward to help narcissists
remain productive. We discussed the impact of leaders on an organization’s value and culture. The impact of
national cultures on domestic organizations was also discussed. We identified the leadership skills necessary for
directing strategic change and looked at some of the obstacles to change. Theory E and Theory O strategic changes
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were introduced as we discussed the importance of successfully combining them to simultaneously achieve lasting
change and an increase in shareholder value. The chapter ended with a discussion of chaos theory and its implication for leaders.
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CASE EXAMPLE Transformational Leadership
Transformational leadership implies that people will follow a leader who inspires them with a shared set of values and beliefs. The leader must be authentic, empathetic, and establish mutually beneficial goals. This allows a
leader to change behaviour within the organization in pursuit of his or her vision. Of course there will be resistance, and a leader’s ability to communicate, persuade, and convince detractors will be crucial. In addition, it is
often said that a leader must possess charisma, personality, energy, and enthusiasm.
When Kazuo Inamori took over as chairman of the near-bankrupt Japan airlines, he was faced with senior
managers; graduates from prestigious Japanese universities who used to plan and implement strategy without
leaving their desk. He quickly abandoned this top-down management approach and encouraged everyone to
take responsibility for the company success. By the time he left, service had improved, flight routes had been
rationalized, staff cut, and the company had relisted on the Tokyo stock exchange.
When Brian Pitman was CEO of Lloyds Bank, he transformed the company’s culture in order to get individuals
to focus on shareholder value. What Pitman realized was you cannot impose your ideas on people within the
organization. Change is part of a learning process in which you persuade people that an objective is worthwhile
before they will apply their skills to achieve it. This process allows for disagreement and challenge, recognizing
that disagreement is the key to getting agreement. In other words, if you don’t allow for open disagreement,
people may simply agree, but without any real commitment to the goal.
Davor Tomaskovic is CEO of Hrvatski Telekom (HT). To date, he has led three corporate transformations in
three different industries. In 2004, he was CEO at a retail and distribution group called Tisak which he successfully turned around to become the dominant player in its sector. In 2006, he was CEO of TDR, a Croatian tobacco
manufacturer which faced a challenge and regulatory environment. When Tomaskovic joined HT in 2014 as
its most senior executive, HT had been losing market share to competitors. A leader was needed who would
transform the company’s fortunes.
The main activity of Hrvatski Telekom (HT) is the provision of telecommunications services, design and construction of communications networks in Croatia. HT is the leading provider of digital solutions that enable the
development of the digital economy in Croatia and the surrounding region. Its parent company is the German
telecommunications firm, Deutsche Telekom. Tomaskovic’s goal was to stop the decline at HT and develop a
new growth strategy. A major issue for Tomaskovic was that people were missing the targets set by Deutsche
Telekom, in spite of their hard work. This was leading to a demotivated workforce who felt blamed for targets
outside their control. In fact, telecommunication companies throughout Europe were in decline. Tomaskovic
needed to demonstrate that HT was in an unsustainable position, in which revenues continued to decline faster
than costs.
Company Values
HT is based on a system of values which is defined by the Guiding Principles of the Company. The Principles provide guidelines for all staff to follow, which promotes ethical behaviour, mutual respect, team work, and open
expression of opinions. The intention is to create an organization that encourages, recognizes, and appreciates
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exceptional results. By promoting common standards of behaviour towards customers and employees, HT
seeks to create a working atmosphere that is a pleasure to work in and contributes to the overall business success of the firm.
These Principles can be seen as a set of aspirational values. The intention is not to provide a set of rules that
employees must obey, but rather values which motivate, inspire, and guide behaviour. The values encourage
staff to achieve their best results, individually, as well as in teams, for the overall good of the company.
After undertaking initial discussions with staff, Tomaskovic began to de-layer the organization by reducing
the number of managers. He rotated the remaining managers to different positions in the organization. By
placing managers in new roles, this brings a new perspective on challenges facing the organization. In addition, he immediately replaced most of the board members in order to have a team which agreed with his
vision for the company and was prepared to implement it. Often, board members will fight change simply
because they have too much social capital invested in previous decisions, and any change is an admission of
their mistakes.
The problem for most organizations is that once the initial changes have taken place people have a natural
tendency to slip back into the old ways of working. The challenge for any CEO is to inspire employees to keep the
change momentum going. In order to avoid employees refreezing back into old habits, Tomaskovic instituted a
three-year transformation program. The aim was to help staff see the need for change, but also to focus on what
the company required to grow and increase profitability. The first year was about building credibility, as well as
reducing costs. In other words, as the changes instituted allowed employees to achieve their targets and enjoy
the benefits, so they were prepared to take on new challenges.
When a CEO is unable to achieve credibility in his initial transformational plans, then it is unlikely that
staff will be prepared to change their behaviour. Therefore, it is crucial for the leader to identify the correct priorities at each stage of the transformation. For example, Tomaskovic did not prioritize the organization’s energies into changing the culture, but focused instead on achieving results. In year two, the focus
moved to improving the customer experience. While year three involved improving revenues and increasing growth.
As CEO at HT, Tomaskovic employs and encourages open discussions with all his managers, believing this
to be the best leadership style. However, once a decision is agreed he expects all his managers to support
that decision, irrespective of the views they may have held previously. He views his role as leader as collating
the expert knowledge embedded in peoples’ experience in the company, and using this information to reach
informed decisions. Another important role of the leader is to understand the critical success factors in an industry, so that the impact of business decisions is evident.
Questions
1. How did CEO, Davor Tomaskovic, overcome employees’ resistance to change at Hrvatski Telekom?
2. How did he prevent staff from falling back into their old ways of working?
Sources: Andrew Hill, ‘Kazuo Inamori, Kyocera founder, rails against complacency’, Financial Times, 28 May 2017; B. Pitman, ‘Leading for value’, Harvard Business
Review, April 2003; ‘Leading a corporate transformation’, Mckinsey Quarterly, January 2017; HT: http://www.t.ht.hr/en/#section-nav
10
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Review Questions
1. Under what conditions might a narcissistic leader be good for company performance?
2. Why is strategic change difficult for organizations to implement?
3. Explain why both Theory E and Theory O are important for organizational change.
Discussion Question
Learning organizations do not exist in reality because individuals simply do not want to change. Discuss.
Research Topic
Consider the following: Steve Jobs, former CEO of Apple, Mike Ashley of Sports Direct, and Fred Goodwin, former
CEO of Royal Bank of Scotland: to what extent is each of these individuals a narcissistic leader? Justify your
answers with reference to the business decisions and remarks that each has made.
Recommended Reading
For a discussion of the respective roles of management and leadership, see:
●
J. P. Kotter, ‘What leaders really do’, Harvard Business Review, vol. 68, no. 3 (1990), pp. 103–11.
The learning organization is covered in:
●
P. M. Senge, ‘The leader’s new work: building learning organizations’, Sloan Management Review,
vol. 32, no. 1 (1990), pp. 7–23.
For an assessment of emotional intelligence on company performance, see:
●
D. Goleman, ‘What makes a leader?’, Harvard Business Review, vol. 76, no. 6 (1998), pp. 93–102.
10
For research on the importance of culture for leaders, see:
●
G. Hofstede, Cultures and Organizations: Software of the Mind, McGraw-Hill, 1997.
www.oup.com/uk/henry3e/
Visit the online resources that accompany this book for activities and more information on strategic leadership.
References and Notes
1
P. Northouse, Leadership: Theory and Practice, Sage, 2016, p. 6.
2
For a discussion of influence and power, see Northouse, n. 1, p. 10.
3
J. P. Kotter, A Force for Change: How Leadership Differs from Management, Free Press, 1990; J. P. Kotter, ‘What
CHAPTER 10 Strategic Leadership
299
J. C. Collins and J. I. Porras, Built to Last: Successful Habit of Visionary Companies, Harper, 1994.
5
R. Rumelt, Good Strategy Bad Strategy: The Difference and Why It Matters, Crown Business, 2011.
6
Rumelt, n. 5, chapter 7.
7
M. E. Porter, ‘What is strategy?’, Harvard Business Review, vol. 74, no. 6 (1996), pp. 61–78.
8
E. Brynjolfsson, A. A. Renshaw, and M. van Alstyne, ‘The matrix of change’, Sloan Management Review,
vol. 38, no. 2 (1997), pp. 37–54.
9
B. George, Authentic Leadership: Rediscovering the Secrets to Create Lasting Value, Jossey-Bass, 2003.
10
J. P. Kotter, A Force for Change: How Leadership Differs from Management, Free Press 1990; J. P. Kotter, ‘What
leaders really do’, Harvard Business Review, vol. 68, no. 3 (1990), p. 107.
11
R. M. Cyert, ‘Defining leadership and explicating the process’, Nonprofit Management and Leadership, vol. 1,
no. 1 (1990), pp. 29–38.
12
G. Stalk, ‘Time—the next source of competitive advantage’, Harvard Business Review, vol. 66, no. 4 (1988),
pp. 41–51.
13
P. M. Senge, The Fifth Discipline, Century, 1990; P. M. Senge, ‘The leader’s new work: building learning
organizations’, Sloan Management Review, vol. 32, no. 1 (1990), pp. 7–23.
14
R. M. Kanter, The Change Masters, Simon & Schuster, 1983.
15
Brynjolfsson et al., n. 8.
16
M. Gladwell, The Tipping Point, Abacus, 2000.
17
S. Finklestein, ‘Why smart executive fail: four case histories of how people learn the wrong lessons from
history’, Business History, vol. 48, no. 2 (2006), pp. 153–70.
18
Rumelt, n. 5, chapter 4.
19
D. Goleman, ‘What makes a leader?’, Harvard Business Review, vol. 76, no. 6 (1998), pp. 93–102.
20
Rumelt, n. 5, p. 94.
21
Cyert, n. 11.
22
M. Maccoby, ‘Narcissistic leaders: incredible pros, and inevitable cons’, Harvard Business Review, vol. 78, no. 1
(2000), pp. 69–77.
23
I. Martin, Making It Happen, Fred Goodwin, RBS, and the Men Who Built the British Economy, Simon & Schuster,
2014.
24
Martin, n. 23.
25
B. Groysberg, A. N. McLean, and N. Nohria, ‘Are Leaders Portable?’, Harvard Business Review, vol. 84, no. 5
(2006), pp. 92–100.
26
T. J. Peters, ‘Leadership: sad facts and silver linings’, Harvard Business Review, vol. 57, no. 6 (1979), pp. 164–72.
27
H. Mintzberg, ‘Crafting strategy’, Harvard Business Review, vol. 65, no. 4 (1987), pp. 66–75.
28
Peters, n. 26, p. 170.
29
Peters, n. 26, p. 171.
30
G. Hofstede, Cultures and Organizations: Software of the Mind, McGraw-Hill, 1997.
31
Hofstede, n. 30, p. 28.
10
leaders really do’, Harvard Business Review, vol. 68, no. 3 (1990), pp. 103–11.
4
10
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32
W. E. Schneider, ‘Why good management ideas fail’, Strategy and Leadership, vol. 28, no. 1 (2000), pp. 24–9.
33
Schneider, n. 32.
34
This section draws upon P. Northouse, n. 1, p 6.
35
M. F. R. Kets de Vries, ‘Charisma in action: the transformational abilities of Virgin’s Richard Branson and ABB’s
Percy Barnevik’, Organizational Dynamics, vol. 26, no. 3 (1998), pp. 7–21.
36
Leo Lewis, ‘Stringer gives up song and dance act as Sony pulls itself together’, The Times, 5 February 2010.
37
J. Lee and D. Miller, ‘People matter: commitment to employees, strategy and performance in Korean firms’,
Strategic Management Journal, vol. 20, no. 6 (1999), pp. 579–93; J. P. Kotter, ‘What leaders really do’, Harvard
Business Review, vol. 68, no. 3 (1990), pp. 103–11.
38
Kets de Vries, n. 35, p. 10.
39
Kets de Vries, n. 35, p. 13.
40
Kets de Vries, n. 35, p. 19.
41
Collins and Porras, n. 4.
42
M. Beer and N. Nohria, ‘Cracking the code of change’, Harvard Business Review, vol.78, no. 3 (2000),
pp. 133–41.
43
Beer and Nohria, n. 42, p. 139.
44
R. Stacey, R., ‘Strategy as order emerging from chaos’, Long Range Planning, vol. 26, no. 1 (1993), pp. 10–17;
R. D. Stacey, Strategic Management and Organizational Dynamics: The Challenge of Complexity, 4th edn,
Prentice Hall, 2003; R. D. Stacey and C. Mowles, Strategic Management and Organizational Dynamics: The
Challenge of Complexity to Ways of Thinking about the Organisation, 7th edn, Pearson, 2016.
45
Rumelt, n. 5, chapter 7.
46
M. E. Porter, The Competitive Advantage of Nations, Free Press, 1990, chapter 3; M. E. Porter, ‘The competitive
advantage of nations’, Harvard Business Review, vol. 68, no. 2 (1990), pp. 73–9.
CHAPTER 11
CORPORATE GOVERNANCE
11.1 What is Corporate
Governance?
11.2 The Origins of
Corporate Governance
11.3 The Growth
of Modern
Corporations
11.4 The Purpose
of Corporations
Extension
Material
Importance of
corporate social
responsibility
11.5 Corporate
Governance Codes
Main Reference
Cadbury, A. (1992).
Report of the
Committee on the
Financial Aspects of
Corporate Governance
(Cadbury Report). Gee,
London.
11.6 Excessive
Executive Pay
11.7 Is reform to
Corporate Governance
Reform the Answer?
Extension
Material
Controversy
surrounding
executive
remuneration
Learning Objectives
After completing this chapter you should be able to:
●
●
●
●
●
Explain what is meant by corporate governance
Discuss the growth of modern corporations
Evaluate shareholder and stakeholder theories of corporate governance
Discuss corporate governance codes
Assess excessive executive pay
Discuss corporate governance reform
11
●
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Introduction
In assessing organizational performance in Chapter 4, we started to evaluate the role and purpose of business. We
can expand on this issue to show how approaches to corporate governance, and indeed business ethics, reflect how
we define business. That is, if the purpose of business is defined as maximizing the long-term value of owners or shareholders, then the role of corporate governance will be relatively narrow. If, however, the purpose of business is defined
as congruent with all its stakeholders—customers, suppliers, and the local community—then the role of corporate
governance becomes somewhat wider. Although we evaluate corporate governance in this chapter, it may be more
properly thought of as permeating all business decisions. As such, it needs to be an integral part of the strategy of
organizations.
Corporate governance is inextricably bound up with one’s views of the purpose of corporations and, indeed, how
one defines a corporation or business. Although different definitions of corporate governance exist, these only really
make sense when we place them in the context of the purpose of corporations. We start our discussion of corporate
governance with a review of the origins of corporate governance and a discussion of the corporate form. We explain
the reasons for the growth of modern corporations, which in turn has led to an increase in the separation of ownership
and control. We then evaluate the different perspectives that exist on the role of corporations.
This is important because a divide exists between those who advocate a shareholder approach to corporate governance and those who adopt a stakeholder approach. The collapse of major corporations more than anything else has
put corporate governance on the boardroom agenda. We review corporate collapses and regulatory codes to determine if lessons can be learned to avert further failures. We also discuss whether executive pay should represent some
multiple of the average worker’s salary. We end the chapter with a discussion of corporate governance reform, asking
whether anything has really changed.
11
11.1 What is Corporate Governance?
The use of the term corporate governance gained prominence in the UK following the publication of the Report of
the Committee on the Financial Aspects of Corporate Governance in 1992.1 This is commonly referred to as the Cadbury Report after its chairman, Sir Adrian Cadbury. The collapse of major corporations in the UK, such as Polly Peck,
Coloroll, Bank of Credit and Commerce International (BCCI), and the Mirror Group, highlighted a rift between the
annual report and accounts and reality. For example, Polly Peck went from a market capitalization of £1.75 billion to
a deficit of almost £400 million in under four weeks.2 Their annual report and accounts, signed off by external auditors, showed little signs of their true financial state. At the same time, there was growing controversy over directors’
pay which effectively widened the remit of the Cadbury Report. Since then we have had much more substantial
failures as global corporations such as Enron and Lehman Brothers have collapsed, threatening instability across
global financial markets.
Corporate governance has been around since companies began to take their present form. Adrian Cadbury contends that governance issues are about ‘power and accountability. They involve where power lies in the corporate
system and what degree of accountability there is for its exercise.’3 Andrei Shleifer and Robert Vishny state that corporate governance ‘deals with the way in which suppliers of finance to corporations assure themselves of getting a
CHAPTER 11 Corporate Governance
303
return on their investment’.4 In other words, corporate governance is concerned with ensuring that the suppliers of
finance (investors) receive something back from the managers to whom they entrust their funds.
In 2004 the Organization for Economic Cooperation and Development (OECD) produced a set of guidelines entitled
OECD Principles of Corporate Governance. It states that corporate governance ‘involves a set of relationships between
a company’s management, board, shareholders and other stakeholders’. It continues, stating corporate governance
‘should provide proper incentives for the board and management to pursue objectives that are in the interests of the
company and shareholders’.5 Thus, corporate governance provides a structure through which an organization sets its
objectives and its performance is monitored. In 2015, these principles were revised to adapt corporate governance
frameworks to rapid changes in both the corporate and financial landscape.6 In common with Shleifer and Vishny,
the OECD sees the main governance problems as arising from the separation of ownership and control. However, it
does recognize that a corporation needs to be aware of the interests of communities in which it competes if it is not to
damage its reputation and long-term success.
While others also see the emphasis on setting and achieving strategic objectives, they argue accountability is to an
organization’s stakeholders. Ada Demb and F-Friedrich Neubauer define corporate governance as ‘the process by
which corporations are made responsive to the rights and wishes of stakeholders’.7 According to Ron Baukol the fundamental basis of corporate governance and responsibility is the value system of the organization. In contrast to others,
Baukol argues that corporate governance is necessary to counteract a tendency for corporations to be selfish and
myopic. He suggests that the role of corporate governance is to guide corporations to achieve corporate and societal
responsibilities.8 There are some who would vehemently disagree with this.
Does corporate governance enhance corporate performance or, by placing an added burden on corporations, does
it stifle enterprise and initiative? In the UK, the Hampel Committee viewed the benefit of corporate governance in its
contribution both to business prosperity and to accountability. However, the Committee’s concern was that ‘accountability had occupied too much public debate suggesting’ the balance needed to be corrected’.11 However, good corporate governance should not imply an either/or scenario. The pursuit of best practice for accountability should enhance
an organization’s performance and not reduce it. Indeed, Thomas Clarke sees the two as mutually compatible: he
argues the pursuit of enterprise must work within a sound framework of accountability, and the balance between
them is critical.12 He is not alone; Jonathan Charkham points out, ‘good governance means a proper balance between
enterprise and accountability’.13
The Institute of Chartered Accountants in England and Wales (ICAEW) argues that there are two fundamentals to
corporate governance. The first is that shareholders have primacy over all other stakeholder groups because it is
11
The emphasis on agency theory, prevalent in the US, in which one party, the principal, provides capital to another
party, the agent, to employ on his behalf, tends to obscure the role of corporations being managed in the interest of
stakeholders. Instead, the focus is on the return on investment of owners.9 The Cadbury Committee believed that a
country’s economy depends on the drive and efficiency of its companies. Thus, the effectiveness with which boards
discharge their responsibilities determine a country’s competitive position. For Cadbury, boards of directors must be
free to drive their companies forward, but must exercise that freedom within a framework of effective accountability.10
There is general agreement that publicly quoted companies, which are a country’s main source of growth, also carry
with them responsibility for the people who are affected by their actions or inaction.
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their money at stake. The second draws upon the Cadbury Report in stating that the foundations of corporate governance are based on the way in which companies are directed and controlled. There is an explicit expectation that
where stakeholders are included the role of shareholder remains one of primacy. In undertaking a review of the role
and effectiveness of non-executive directors in the UK, the Higgs Committee declared that corporate governance
‘provides an architecture of accountability—the structures and processes to ensure companies are managed in
the interests of their owners’, although it went on to acknowledge that architecture in itself does not deliver good
outcomes.14
Although a definition of corporate governance that is acceptable to all parties is difficult to find, we do know that
following the collapse of Lehman Brothers in 2008, policy makers around the globe continue to debate corporate
governance. They seek to ensure that those in positions of trust behave responsibly and morally. Terms such as ethics,
morals, and right and wrong that have arguably been implicit in boardrooms now have a more explicit resonance.
11.2 The Origins of Corporate Governance
11
The origins of corporate governance date back at least as far as 1600, when a Royal Charter was granted to The Company of Merchants of London trading into the East Indies.15 The governance structure of the East India Company consisted of a Court of Proprietors and a Court of Directors. The Court of Proprietors comprised individuals with voting
rights, which they received as a result of contributing a sum of money of around £200. The Court of Proprietors seldom
met because it comprised hundreds of individuals, but it had ultimate authority. Its authority was required to raise
funds and to appoint directors. The Court of Directors was the executive body which was responsible for the running of
the company, appointing a chief executive, and setting the strategy direction, although each policy decision required
agreement by the Court of Proprietors. The Court of Directors consisted of a governor, a deputy-governor, and twentyfour directors who met frequently.
The structure of the East India Company has clear antecedents with modern companies today. The Court of Proprietors were the shareholders, the Court of Directors was the board, and the Royal Charter laid down the framework
in which the company operated. Similarly, the issues faced by their board will resonate with modern companies.
Some investors adopted a short-term horizon, requesting a return on their money after each sea voyage, while
others adopted a longer view. The Court of Directors had the added problem of controlling appointees such as sea
captains for the voyage to the East Indies. These individuals were acting not only for the company, but also often
for themselves in faraway places without communication for long periods of time. Cadbury argues that corporate
governance issues are rooted in the development of the corporation. They are about power and accountability. In
shareholder-owned corporations, the balance of power between shareholders, boards of directors, and managers
is continually shifting.
The corporate structure has continued to develop in response to needs that were not being met by earlier corporate
forms. In 1932, US Supreme Court Justice Louis Brandeis argued ‘the privilege of engaging in such commerce in corporate form is one in which the state may confer or may withhold as it sees fit’.16 It is interesting to reflect that, for Brandeis,
the conferring of corporate status went hand in hand with the needs of public policy and welfare. His concern was
that a corporation was used to benefit the public. He went on to state that even when the value of the corporation in
commerce and industry was fully recognized, ‘incorporation for business was commonly denied long after it had been
freely granted for religious, educational, and charitable purposes’.17
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For Brandeis, incorporation for business was denied because of a fear that the corporation may use its power to subvert
the needs of employees to the needs of investors. With insight, he noted that there was: ‘a sense of some insidious
menace inherent in large aggregation of capital, particularly when held by corporations’. As a result, incorporation
was granted sparingly; usually when it was necessary to procure for the community some specific benefit that would
otherwise be unattainable. That incorporation became more common did not signify to him that concerns about
corporate domination had been overcome.
While few would deny the enormous benefits and affluence that modern corporations have brought, Brandeis, like
the economist John Kenneth Galbraith after him, was wary of the influence of overarching powerful corporations.
11.3 The Growth of Modern Corporations
The spread and acceptance of the modern corporation is owed to four characteristics: (1) limited liability of investors;
(2) free transferability of investor interest; (3) legal personality; and (4) centralized management.18
11.3.1 Limited Liability
Limited liability involves a separation between the corporation and its owners and employees. This ensures that
what is owed to the corporation is not owed to the individuals that make up the corporation. Also, whatever debts
the corporation owes are not owed by individuals that make it up. Thus, if a corporation becomes bankrupt and is
pursued by its creditors for recovery of debts, the individual members of the corporation are not individually liable.
The corporate form provides certainty for investors as to the extent of their loss; it will only ever be the amount of
capital they have invested in the firm. However, limited liability is accompanied by limited authority to influence the
direction of the corporation. It is the shareholders’ low level of risk derived from having limited liability that makes
their low level of control acceptable.
An ability to transfer one’s holdings freely also provides the shareholder with an acceptable level of risk. A shareholder
who is concerned that their shares may be losing value can sell almost immediately. However, this does imply some
timely information that would prevent the shareholder incurring further losses. Often by the time this information is
disseminated to individual shareholders their holdings may have substantially fallen in value. Transferability is a function of limited authority. The shareholders agree to put their capital at risk. They have little authority to control the
corporation, but they have the assurance that they can have some control over their risk by selling their investment
when they want to.
11.3.3 Legal Personality
Whereas a partnership dissolves with the death of its partners, a corporation lives for as long as it has capital. A legal
personality ensures that actions that would result in a negative sanction for an individual have no such consequences
when the individual commits them as part of a corporation. Recently, in the UK, corporate manslaughter has been
invoked in an attempt to hold negligent directors to account. As corporations are defined as legal persons, they may
own property, including copyrights.
11
11.3.2 Transferability
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11.3.4 Centralized Management
The board of directors determines the setting of a company’s aims and objectives, and therefore its strategy; managers
control its day-to-day operational issues. For the board to drive the company purposefully into the future, it needs to be
aware of the opportunities that exist in the marketplace and how best to exploit these. Cadbury argues that it is insufficient for the board simply to determine aims and objectives without also considering the manner of their achievement.
Thus, although the board is responsible for devising strategy it needs to undertake these decisions in consultation with
management, who have the task of achieving the results. As corporations grew in size and age, their ownership became
more dispersed and markets developed to provide for far greater liquidity. At the same time, directors acting on behalf
of shareholders are expected to invoke the same sense of duty and care they exercise with their own affairs.
11.4 The Purpose of Corporations
The purpose of the corporation is far from unambiguous. Theoretical perspectives abound that are rooted in ideology
and dogma. The growing concern within corporations for the needs of stakeholders and society has had the effect
of polarizing these perspectives. To understand corporate governance, corporate social responsibility, and business
ethics, we need to address the fundamental question: why do businesses exist?19
Before we do so, we can define what we mean by a corporation. Robert Monks and Nell Minow remind us that definitions of the term corporation invariably reflect the perspectives and biases of those writing the definition. They state:
‘a corporation is a mechanism established to allow different parties to contribute capital, expertise, and labour, for the
maximum benefit of all of them’.20 They argue that a corporation has to relate to a wide variety of constituents including
directors, managers, employees, shareholders, customers, and suppliers, as well as society and the government, and
that each of these relationships has the ability to affect the direction and focus of the corporation. It is generally agreed
that a corporation is an organization owned by its shareholders, but managed by agents on their behalf.
11
Baukol contends that a better understanding of corporate governance and corporate social responsibility21 derives
from an understanding of the role of the corporation in modern society, or fundamentally answering the question:
why does a corporation exist? Mary O’Sullivan makes the same point, asserting that an understanding of corporate
governance needs to first address what the objectives of the corporation are or what a company is in business to do.22
Once the objectives are established, discussions of corporate governance focus on the mechanisms that will ensure
goal achievement. If a firm wants to maximize shareholder value, the relevant governance mechanisms are those
influencing the relationship between shareholders and corporate managers.
Elaine Sternberg argues that it is necessary to first understand what business is (and is not) by disaggregating it from
other forms of activity. Sternberg argues that the defining purpose of business (a corporation) is ‘maximizing owner
value over the long term by selling goods and services’.23 For Baukol, corporations exist because, unlike other institutions such as government, the corporation provides economic sustainability. The corporation is unique in allowing
individuals to practise their skills in a group setting that creates employment and value which others are prepared
to pay for. The corporation generates wealth for society and for its own members. Few would argue with Baukol’s
assertion that the corporate entity is the major institution for wealth creation. The arguments surround the role and
responsibilities of corporations. As Brandeis noted, the corporation will not necessarily pursue the interests of the
society of which it is a part.
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307
If we take corporations, there is an assumption that these organizations are in business to create value and that the
profit they produce is to be distributed among the owners of the business, the shareholders. We saw in Chapter 4 that
there is a presumption that the objective of corporations is to maximize profits. This is standard neoclassical economic
theory. In the 1930s, Berle and Means cast doubt on profit-maximizing theories. They were not proposing a shift away
from profit-maximizing, but rather questioning whether this actually occurs.24 Indeed, in an article in the Harvard Law
Review, Berle states, ‘you cannot abandon emphasis on the view that business corporations exist for the sole purpose
of making profits for their shareholders until … you are prepared to offer a clear and reasonably enforceable scheme
of responsibilities to someone else’.25
Their concerns were around the principal–agent problem. The principal–agent problem refers to the separation of ownership from control within corporations. The owners are the principal, but control of the organization is by salaried
managers who act as the agent. There is a tendency for an asymmetry of information to exist when managers are
running companies which are owned by numerous dispersed shareholders. This asymmetry of information between
the principal (owners) and the agent (managers) occurs when managers have access to corporate information which
the owners do not. The dispersal of shareholders is related to the legal framework that exists within different countries.26
However, the profit-maximizing assumption is contested by behavioural psychologists who claim organizations consist
of shifting coalitions and how they behave is dependent on the interests and beliefs of the dominant coalition(s).27
It is apparent that the purpose of corporations is by no means clear. Many of the arguments are rooted in ideology. With
this in mind, we can evaluate the two main perspectives based on shareholders and stakeholders.
11.4.1 The Purpose of Corporations: Maximize Shareholder Value
Friedman’s contention is that corporate executives act as agents and, therefore, to engage in forms of corporate social
responsibility is using their position to spend someone else’s money for a general social interest.29 The effect of such
activities is to impose a tax on the owners by ensuring that they receive lower returns from their investment than they
otherwise would. If the effect of such actions by corporate executives raises prices for consumers, then this places a tax
on consumers. Likewise, if the effect of such actions lowers the payments some employees receive, they are effectively
taxed. Indeed, Sternberg would argue that in the case of corporations, organizations owned by shareholders, the use
of an organization’s resources by managers for anything other than business purposes is tantamount to theft.30 The
fact that managers may be involved in the pursuit of socially responsible aims does not mitigate their actions and still
amounts to embezzling shareholders’ wealth.
Friedman does not recognize a social role for the corporations that would encompass the needs of stakeholders; his
concern is for the shareholders. However, he does argue against the violation of accepted legal business practices.
In this respect Friedman would have perceived the fraudulent use of corporate funds as a gross misallocation of
resources which ultimately leads to suboptimal decision making for shareholders. Friedman asserts a role for the corporation that is rooted in his ideology of the market mechanism and political economy. He states: ‘in a free enterprise,
11
In the US and the UK there exists a predominant belief that the role of corporations is to serve the owners of the business; that is, the shareholders. In a much quoted passage, the Noble prize-winning economist Milton Friedman argues,
‘there is one and only one social responsibility of business—to use its resources and engage in activities designed to
increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition
without deception or fraud’.28
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private property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers.’31
Friedman’s concern is that the blurring of corporate executives’ boundaries of responsibilities resulting from intrusions
into social responsibilities would ultimately lead to an erosion of free enterprise and the onset of a socialist state. The
very act of executives being involved in decisions that are in the domain of the political arena turns such executives
into public employees and civil servants; though they remain employees of a private enterprise. And if they are public
servants they must be elected through a political process and not chosen by shareholders. Friedman does concede
that actions he terms ‘social responsibility’ may be in a corporation’s self-interest and, therefore, justified to some
limited extent.
The context for Friedman’s ideas is the American Business Model (ABM); often referred to as the Washington consensus. This has been the dominant economic and political philosophy for the past four decades. The ABM is based on
four claims.32 (1) Self-interest: It is self-interested materialism of individuals that govern their lives. (2) Market Fundamentalism: Markets must be allowed to operate freely without any political interference This is on the belief that the
regulation of markets is invariably inefficient. (3) A minimal role for the State: The economic role of the government
should be largely limited to the enforcement of contracts and private property rights It should not be to provide goods
and services, or to own productive assets. (4) Low Taxation: The use of taxation is to finance the activities of a minimal
state. And as a result, taxation should be as low as possible. The tax system should not be used to redistribute income
and wealth within society.
11
The belief in the free market draws upon the work of Italian economist, Vilfredo Pareto. He devised what is called a
Pareto efficient state. This describes an economic situation in which you cannot make the circumstances of one person
better off without making another person worse off. The de facto assumption of the ABM is that markets are Pareto
efficient. Therefore, were the Government to intervene in the allocation of resources it would simply result in a Pareto
inefficient state: it would make things worse. Indeed, the only reason for the state to intervene in the allocation of
resources would be if it could achieve a Pareto improvement. A Pareto improvement describes an economic situation
in which you can make someone better off, but without making anyone else worse off. It goes without saying that
advocates of the ABM do not see this as a role for government.
John Kay offers an incisive critique of the ABM.33 Kay argues that allowing maximum freedom in a framework of rules
is bound to fail, and does fail. This is because playing within ‘the rules of the game’ does not so much exclude unacceptable behaviour as define the limits of what is permissible. Ultimately, the integrity of an organization does not result
from its governance structure; it reflects the values of those who work within it. Thus, the central tenet of the ABM, that
business activity can be successfully organized around self-regarding individuals constrained by externally imposed
rules, is misplaced.
Kay argues the account of the market economy proposed by the ABM is not an accurate description of how even
the US economy functions.34 For example, property rights are not fixed, but are part of social constructs. Furthermore, markets operate in a social context which is not separate from our economic lives, but integral to it. The reason why market economies have, for example, outperformed planned societies is not as a result of the ubiquity of
greed or self-regarding materialism. It comes from an understanding of the power of disciplined pluralism. In other
words, the primary strength of the market economies is that they provide freedom to experiment and opportunity to
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T he Body Shop is known for its social activism, including an alliance with the charity Greenpeace and campaigns to end cosmetics testing on
animals. Source: © Nils Versemann/iStockphoto
imitate successful innovation. At the same time, market economies will quickly terminate unsuccessful experiments. In
planned economies, this is not the case; innovations tend to be slow and they are allowed to continue when they fail.
Jack Welch believes that managers and investors should not have share price increases as their overall goal. Welch
maintains that any short-term profits should be allied with an increase in the long-term value of a company. As
he states, ‘On the face of it, shareholder value is the dumbest idea in the world.’ He went on to add: ‘The idea that
shareholder value is a strategy is insane. It is the product of your combined efforts—from the management to the
employees.’37 For Welch, shareholder value is a result, not a strategy to be pursued. Ironically, the shareholder value
movement is commonly traced to a speech given by Welch at New York’s Pierre hotel in 1981, shortly after becoming
CEO of GE.
11.4.2 The Agency Problem
The principal–agent framework has occupied economists since the time of the Scottish economist Adam
Smith. In the eighteenth century, Smith documented what is now known as the agency problem. The agency
problem arises because of the separation between ownership of an organization and its control. It is inherent in the
11
Anita Roddick, the founder of The Body Shop, openly advocated the pursuit of social causes as a legitimate business
practice.35 Given the values of its founder, which clearly permeated the organization, it was somewhat surprising to
see The Body Shop acquired by the French multinational L’Oréal. In 2017 The Body Shop was sold to the Brazilian
make-up company Natura Cosmeticos for €1bn (£880m). The former Chairman of Cadbury Schweppes, Sir Adrian
Cadbury, maintains the fact that companies such as The Body Shop pursue wider objectives demonstrates that not all
shareholders are concerned with maximizing profits.36 The issue for Cadbury is not whether an organization is pursuing social objectives per se, but whether this is transparent. Transparency allows shareholders to make informed
decisions about whether to invest in these companies.
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relationship between the providers of capital, referred to as the principal, and those who employ that capital,
referred to as the agents.
Smith’s concern was that any given person will simply not watch over another person’s money in the same way as
they would watch over their own money. As the directors of companies are managers of other people’s money, Smith
asserts it cannot be expected that, ‘they should watch over it with the same anxious vigilance which the partners in
private co-partnery frequently watch over their own … negligence and profusion, therefore, must always prevail in
the management of the affairs of such a company’.38
Michael Jensen and William Meckling state that an agency relationship exists when one party, the principal, contracts
work from another party, the agent, to perform on their behalf. However, this agency relationship can give rise to a
number of agency problems.39 These occur because no contract, however precisely drawn, can possibly take account
of every conceivable action that an agent may engage in. The question arises as to how to ensure that the agent will
always act in the best interest of the principal. The spread of modern corporations has brought about a separation
between the owners of corporations and those who manage those corporations on their behalf. Agency costs occur
when there is a divergence between these interests. Thus, agency costs can be seen to be the costs associated with
monitoring agents to prevent them acting in their own interests.
11
There is increasing pressure on institutional shareholders to take a more active role in the corporations in which they
invest. This has been driven by corporate scandals which revealed a lack of non-executive director effectiveness,
and a tendency, widely reported in the media, for boards of directors to be remunerated for poor performance. This
has prompted a call for greater transparency and disclosure in an attempt to rebalance the information asymmetry
between principal and agent and to provide investors with more timely information about their company’s activities.
The agency problem continues to be important in governance terms because it has an influence on the structure
and composition of boards. It also affects the requirements for disclosure, and the balance of power between shareholders and directors.40
Berle and Means argue that the separation of ownership from management has resulted in shareholders being
unable to exercise any form of effective control over boards of directors. However, Cadbury argues that issues of
accountability did not arise simply because ownership was divorced from management, but more so because ownership was increasingly dispersed. As he states, ‘It was the fragmentation of ownership that neutered the power
of shareholders.’41 This dispersal of ownership is a double-edged sword. The fact that many holdings are small
means that shareholders have no difficulty in selling their shares if they lose confidence in the management of their
corporation. However, when the majority of shareholdings are small, shareholders are less able to hold the board
of directors to account. As we shall see, small shareholdings in the UK and the US have since given rise to majority
holdings by powerful institutional investors.
11.4.3 The Purpose of Corporations: Meet the Needs of Stakeholders
We have seen that where the focus is on shareholders there is a presumption that shareholder value is the dominant
objective of the organization. An alternative approach, which is seen to have acquired greater legitimacy following the
collapse of Enron42 and subsequent financial scandals, is a view of the organization that serves the interest of stakeholders. According to R. Edward Freeman, stakeholders are those individuals or groups which affect or are affected by
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the achievement of an organization’s objectives.43 They may include customers, suppliers, employees, government,
competitors, the local community, and, of course, shareholders. The primary role of corporations as a vehicle to create
shareholder value is contested by those who advocate a stakeholder approach.
Stakeholders may be separated into internal and external stakeholders. Internal stakeholders are those whose
impact is felt inside the organization, such as employees; external stakeholders have their impact outside the
organization, such as shareholders. This distinction is somewhat arbitrary, since some stakeholders—for example
employees—may also be shareholders and, therefore, occupy both internal and external categories. Those who
suggest that the corporation should serve stakeholders accept that shareholders are the owners of the organization, but reject the notion that this somehow makes them of greater importance in the organization’s decisions.
In fact, they would argue that without the involvement of employees, suppliers, and customers there would be no
business activity. Of course, the same argument can be said of shareholders as the providers of finance—without
which there would be no organization.
Stakeholder theorists argue that many different stakeholders are affected by an organization’s decisions and, therefore, the role of management is to balance the needs of each stakeholder rather than focus upon shareholders only.
For example, the collapse of the Lehman Brothers in the US was felt far beyond the capital loss to shareholders.
Employees who had invested in the corporation’s pension fund found themselves out of work, suppliers suffered
the loss of major contracts, and national and international economies experienced instability. The sheer size of
some corporations requires an explicit recognition by board executives that their actions have a direct impact on
these stakeholders. A narrow definition of shareholder supremacy quickly comes into conflict with the realities of
corporate responsibility.
An example of government intervention was apparent during BP’s disastrous oil rig explosion, which resulted in
eleven deaths and unleashed oil from a well head one mile down into the Gulf of Mexico in 2010. This unprecedented
threat to marine life and coastal livelihoods led to a personal reprimand of BP’s chief executive Tony Hayward and his
company by then US President, Barack Obama. As well as the tens of billions of pounds wiped off BP’s share price during the incident, the organization faced a major loss to its corporate reputation. As events unfolded, the British CEO’s
position became increasingly untenable and he was replaced by an American.
A former Chancellor of the Exchequer, Nigel Lawson, stated emphatically, ‘the business of government is not the government of business’. This was a signal to financial markets and the business community that the Conservative government did not expect to regulate the business community. It was assumed that self-regulation would ensure that
organizations behaved responsibly. In the US, the enactment of Sarbanes–Oxley has signalled a move away from
reliance solely on self-regulation, and marks a recognition of the responsibilities of corporations in the globalized
11
The problem is that stakeholders may exhibit conflicting needs, which makes the task of management in balancing
these different interests very difficult. In an ideal world, it would be great if managers first considered the impact of
their strategic decisions upon different stakeholder groups. In reality, this is seldom possible. This is precisely because
stakeholders themselves may have different objectives that managers are faced with trying to achieve multiple
objectives. One way of trying to prioritize the different interests of stakeholders is to assess the influence they exert
on an organization’s objectives. For example, governments may have a benign interest in the activities of organizations, but be forced to exercise their legislative powers when organizations behave in an unacceptable manner.
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economy. In the UK, following the financial collapse, there has been much debate about the efficacy of ‘light-touch’ or
self-regulation of corporations.
When Nike’s operations abroad did not conform to US health and safety standards for their overseas workers, including
minimum age restrictions on employees, this caused an outcry and was reported worldwide. Although the decision
to employ workers abroad was to enhance profitability, the result was a damaged reputation and an initial fall in sales.
This illustrates that even where an organization’s priority is to create value for its shareholders, it cannot afford to do so
without some understanding of the expectations of stakeholders and society.
Those who adopt a stakeholder perspective expect that organizations will actively pursue measures which result in a
net welfare gain to the environment and society. As such, their criteria for successful performance will differ markedly
from shareholder maximization. An organization cannot afford to ignore the expectations of stakeholders, and many
firms have started to move away from simply paying lip service to important environment issues. The oil industry,
arguably one of the worst polluters, has begun to engage stakeholders in debate about renewable sources of energy.
This is not altruism, but a realization that their interests are inextricably tied to the interests of their wider stakeholders.
Table 11.1 summarizes the key elements of maximizing shareholder value and stakeholder theory.
The Japanese concept of kyosei, loosely translated as ‘living and working for the common good’ has become a
philosophy of doing business for some Japanese corporations.44 From the perspective of kyosei, a corporation is not a
self-sufficient organism set apart from society, but is outward looking, aware of its duty to people outside its organization such as customers, suppliers, and the community. By taking account of this wider network of relationships, the
corporation can be profitable and sustainable over the long run. For example, Panasonic donates solar lanterns to
India to meet the lighting needs of local rural areas.45 Baukol argues that business leadership is not just about financial
success, but that business leaders should also be working to improve their societies, ensuring social, economic, and
environmental sustainability.
From this perspective, the proper course of corporate governance is to manage the relationship of the corporation with
its stakeholders. Although Baukol acknowledges that corporations will continue to create much of the wealth of society,
he sees this is only possible because a corporation is a set of relationships among stakeholders, . And each stakeholderplays a role in the success of the corporation. Corporate social responsibility occurs when an organization takes into
Table 11.1 A comparison of agency and stakeholder theory.
Stakeholder Theory
Main players
Principal (owners/shareholders), agent (manager)
Employees, customers, suppliers, shareholders, local
community, government
Key objectives
Value maximization, i.e. maximize shareholders’ interests
Multiple objectives to try to benefit all stakeholders
Strengths
Clear and achievable
Recognizes that long-term success of the organization
depends on the participation of all stakeholders
Weakness
Maximizing shareholder wealth fails to motivate
employees
Pursuit of multiple objectives is deemed unrealistic and too
difficult for managers to achieve
Key protagonists
Milton Friedman (1962, 1970)
R. E. Freeman (1984)
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Maximise Shareholder Value/Agency Theory
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account the impact of its strategic decisions on society. The British retailer Marks & Spencer announced a £200 million
five-year plan to make the company carbon neutral. Its CEO at the time, Stuart Rose, said, ‘we believe responsible business can be profitable business’.
For further discussion on the importance of corporate social responsibility for organizations, visit
the online resources see the Extension Material for this chapter.
www.oup.com/uk/henry3e/
We can see that without each stakeholder the corporation cannot function efficiently or cannot function at all. Without
capital and shareholders there is no corporate entity. Without banks and other debt investors, the corporation cannot
maximize its ability to earn a return on its capital. But without customers there will be no business for the corporation to do. Similarly, without employees, the corporation will be unable to do business. And if the community loses
confidence in a corporation it may quickly lose its business legitimacy, resulting in collapse. It is only by aligning and
attending to the needs of different stakeholders that the corporation fulfils its duty to society—to promote prosperity
in a sustainable manner.
Stakeholder theory asserts a corporation has duties and responsibilities to different constituents; this presents a number of problems. Sternberg maintains that trying to balance stakeholder needs or benefits is unworkable.46 This is
because using Freeman’s definition of stakeholders leads to an infinite number of stakeholder needs. Furthermore,
stakeholder analysis cannot offer guidance as to which stakeholders should be selected. And if it could, it does not
explain what counts as a bona fide need. Importantly, no guidance is provided as to what weighting each stakeholder
group should have vis-à-vis other stakeholders. For Sternberg, corporate governance is quite simply corporate actions
that ensure that the objectives of the shareholders are adhered to.
It is clear that the role of corporations is changing. Cadbury states: ‘society’s expectations of the role of companies in
the community are changing and … . Companies need to engage with those groups which can affect their ability to
conduct their businesses.’ He goes on to say that ‘companies should stand their ground for what they believe to be in
their and society’s interests, even if this may lead at times to confrontation’.48
11.5 Corporate Governance Codes
There is a presumption that corporate managers can be left to act in the best interests of shareholders. This thinking is
based on the belief that a poorly performing company will be the subject of takeovers, the threat of which is sufficient
to discipline managers to act in the shareholders’ interests. However, the reality does not always bear this out. Instead
11
Can the divide between shareholder value maximization and stakeholder theory be bridged? Jensen proposes enlightened value maximization as a way in which organizations might achieve a trade-off between the competing needs
of stakeholders.47 This is accomplished by accepting the maximization of the long-run value of the organization as
the criterion for trade-offs between competing stakeholders. This single long-term objective, it is argued, solves the
dilemmas managers are faced with when they try to achieve the multiple objectives inherent in stakeholder theory.
It is arguable whether proponents of stakeholder theory would accept this as a dispassionate assessment of the corporation’s activities or simply another way of saying that shareholders’ needs predominate, albeit over the long-term.
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of this threat galvanizing boards of directors to improve their performance, it often leads to them erecting myriad
defences. The evidence suggests the market for corporate control is not a very effective way to discipline management. The reason is that if target shareholders win, bidder shareholders invariably break even or lose value. Aligned to
this, efficiency gains from takeovers are quite low.49
In this respect, takeovers are a costly and inefficient way to change the board of directors. A more efficient way to
encourage better corporate performance might be for institutional investors to engage in dialogue with boards of
directors. Cadbury suggests that this change in the pattern of share ownership in favour of investing institutions has
encouraged the institutions to use their influence with boards. Therefore, rather than simply selling their shareholdings, exit is giving way to voice, as shareholders seek to improve their returns.
Hermes is a UK based institutional investor that is proactive in its dealings with the companies it invests in. It published
the Hermes Responsible Ownership Principles, which detail what they expect of listed companies and what listed
companies can expect from Hermes.50 The intention is to create a common understanding between boards, managers,
and owners of the proper goals of a listed company. It sets out a number of expectations which Hermes believe should
exist between owners, boards, and managers. By being explicit about their expectations of listed companies, it seeks
to create a better framework for communication and dialogue between boards and management on the one hand,
and shareholders on the other hand. This aim is to contribute to better management of companies and the sustainable
creation of value for their shareholders.
Corporate governance came to prominence following a number of high-profile corporate collapses. At the same
time, there was growing controversy over what was seen as excessive directors’ pay and rewarding of poorly
performing directors. Over the past decades the UK has initiated a series of investigations into ways to improve
corporate governance of UK listed companies. These investigations have been high profile, led by experienced
individuals who have given their name to the final report. They include the Cadbury Report, the Greenbury Report,
and the Hampel Report. The recommendations of these three reports were later embodied into a Combined
Code.51
In addition, there have been specialist reviews dealing with institutional investment, Company Law, the governance
of banks and financial institutions, and board diversity. We can address the response to corporate failures by looking at
the Cadbury Committee Report and subsequent reports.
11
11.5.1 The Cadbury Committee
The Committee on the Financial Aspects of Corporate Governance, commonly referred to as the Cadbury Committee,
reported its findings in 1992. It was appointed in the aftermath of the collapse of prominent UK listed companies such
as Polly Peck. However, its remit was widened to include illegal behaviour at Bank of Credit and Commerce International (BCCI), and Maxwell Communications Corporation. The Committee’s sponsors were concerned that the lack of
public confidence in financial reporting and the ability of auditors to provide the safeguards sought and expected by
users of company reports would undermine London as a major financial centre. The voluntary codes of conduct contained in the report have since gained international currency, although they are not without their critics. Some argue
that the focus on the control and reporting functions of boards and the role of auditors is narrow, omitting as it does a
substantive role for stakeholders.
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At the heart of the Committee’s recommendations is a Code of Best Practice. All listed companies registered in the
UK should comply with the Code and explain reasons for any areas of non-compliance. The Committee acknowledged that ‘no system of control can eliminate risk of fraud without so shackling companies as to impede their
ability to compete in the marketplace’. Nevertheless, the Report contained a veiled threat which implied that if
companies were to fail to adopt its Code then legislation was a real possibility. ‘We recognize, however, that if companies do not back our recommendations, it is probable that legislation and external regulation will be sought to
deal with some of the underlying problems which the report identifies.’52 Some of the main recommendations of
the Cadbury Report are as follows:
●
The board of directors should meet regularly, retain full and effective control over the company, and monitor the
executive management.
●
There should be a division of responsibilities at the head of the company to ensure that no one individual has
unfettered powers of decision.
●
Directors’ contracts should not exceed three years without shareholders’ approval.
A division of responsibilities at the head of the company was to separate the positions of CEO and chairman such that
no one individual had unfettered powers of decision making. It was a recognition that the role of the chairman and
the CEO are distinct. Greater emphasis was placed on non-executive directors’ independence from executive board
members. The Report recommended their fee be tied to the amount of time they devoted to the company. All listed
companies had to ‘comply’ or ‘explain’; that is, they either comply with the code or explain in their annual report and
accounts why they are unable to do so. This puts the emphasis on the board of directors and gives shareholders an
opportunity to see which corporations are adhering to the code.
It is widely accepted that of all the codes addressing corporate governance issues, the Cadbury Report has had the
greatest impact on corporate governance development around the world. Many corporate governance reports,
including the King Reports I and II of South Africa, acknowledge their debt to Cadbury. These and other reports tend to
use the Cadbury Report as a blueprint, but tailor the specifics to suit their individual country’s needs.
11.5.2 The Hampel Committee
The Hampel Report confirmed the enhancement over time of shareholder investment as the overriding objective of
companies, but it did so iterating that business prosperity involved many economic actors working together. Thus,
directors can meet their obligations to shareholders and obtain long-term shareholder value only by developing and
sustaining stakeholder relationships. Companies need to be mindful of their responsibilities, but this needs to be
couched within structures and principles that allow businesses to grow and prosper. The Hampel Report argued that
previous reports had placed too great a burden on what it referred to as ‘box-ticking’ at the expense of wealth creation,
although it endorsed the majority of the findings of both committees.
11
The Hampel Committee was set up to review the Cadbury Report and the Greenbury Report on directors’ remuneration. The Hampel Committee saw no inconsistency in not following some Cadbury Report guidelines, such as the
separation of the roles of chairman and chief executive officer, arguing that guidelines will be appropriate in most
cases, but not all. In such cases, the Hampel Committee argued, it would be damaging to a company’s reputation if its
explanation for non-compliance were rejected out of hand.
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11.5.3 Other Corporate Governance Codes
There has been a plethora of corporate governance codes since the Cadbury Report.53 The Combined Code, published
in 1998, brought together the recommendations of the Cadbury, Greenbury, and Hampel Reports.54 It functions on the
‘comply or explain’ formula instituted by Cadbury. Its focus is on companies and institutional investors. Directors are
expected to conduct an annual review of the effectiveness of the organization’s system of internal control and report
to shareholders that they have done so (see Strategy in Focus 11.1). The Myners Report, published in 2001 and
updated in 2008, focused on institutional investment. The Report expects institutional investors to engage in greater
shareholder activism, particularly when dealing with underperforming companies. Following the financial crisis there
was the Walker Review in 2009. Sir David Walker recommended extensive reforms to strengthen governance in UK
banks and increase disclosure on pay.55
In 2008, the Financial Reporting Council (FRC) published an updated Combined Code which removed the restriction
on an individual chairing more than one FTSE 100 company.56 The Combined Code became the UK Corporate Governance Code in 2010. This was a review of the Combined Code and retains the central governance feature of ‘comply or
explain’. In 2014 the UK Corporate Governance Code underwent another revision. This time the focus was on balancing
the information needs of investors against the appropriate reporting requirements for companies.
There has been some concern about the lack of diversity in the boardroom, particularly the under representation of
women. Lord Davies was asked to identify the barriers that might be preventing women from reaching the boardroom.
His initial report was published in 2011, with a review in 2012 and subsequent annual reports.57 A key recommendation of the Davies Report is that FTSE 100 companies should aim for a minimum of twenty-five per cent of women in
the boardroom by 2015. In February 2011, there were 12.5 per cent of women sitting on FTSE 100 boards. By 2015, this
figure had risen to 26.1 per cent.58
11
STRATEGY IN FOCUS 11.1 Tata’s Governance
Profit is to good corporate governance what tides are to swimming trunks: when the former is high, absence
of the latter tends to go unnoticed. The ebbing of profits at Tata, India’s largest conglomerate, in recent years
has prompted a power struggle that in turn has exposed the often dysfunctional relationship between several
dozen businesses, holding companies, people, and charities that use the Tata name. The struggle is now over:
Cyrus Mistry, Tata’s boss until recently, was finally booted out of the company. Natarajan Chandrasekaran, the
boss of one of the group’s key operating firms, Tata Consultancy Services, took over as chairman.
Executives at the 149-year-old group hope that will close a grim chapter in its history. Mr Mistry, whose family
owns an 18 per cent stake in Tata Sons, the main holding company, which is unlisted, reacted badly to being
evicted as its chairman. The move to oust him was set in motion by Ratan Tata, the group’s 79 year old patriarch.
During Mr Mistry’s reign, Mr Tata had remained at the helm of the Tata Trusts, charities that control 66 per cent of
Tata Sons. For months, Mr Mistry refused to step down from chairing the boards of listed Tata firms, such as Tata
Steel or Tata Motors (owner of Jaguar Land Rover), which the group effectively controls, but in which Tata Sons
typically owns a 30 per cent stake. The very last board he clung on to, that of Tata Sons itself, is now rid of him.
Before leaving he made all manner of claims of financial and corporate-governance impropriety at Tata.
Regulators are said to be looking into some of them; Tata denies them all. But in the hundreds of pages of
affidavits filed in various tribunals by both sides, and seen by The Economist, a recurring theme emerges,
that the relationships between the Trusts, Tata Sons, and Tata companies are governed primarily by personal
relationships and deference to tradition. There is little sense that things are going to change. The hope seems to
be that Mr Chandrasekaran can grow profits again and put such problems out of mind.
Mr Mistry’s most striking claim is about the current board of directors of Tata Sons. It is arguably India’s most
august corporate body; directors include the dean of Harvard Business School (HBS), a former Indian defence
secretary, and several respected industrialists. Mr Mistry contends that it is little more than a rubber stamp for
decisions made by the Trusts, i.e., by Mr Tata. A change to the articles of association of Tata Sons in 2014 gave the
Trusts more access to information across the entire group. The Trusts already had the ability to influence decisions by
nominating one-third of the Tata Sons board. Acting together, those directors can veto the entire board’s decisions.
The ousted man says Mr Tata ramped up meddling into the activities of both Tata Sons and some operating firms,
aided by a roster of long-retired executives who serve as Tata trustees. This view is backed by the Tata Group’s top
lawyer, who in January 2016 wrote that if internal documents were somehow leaked to the media, they would
‘project to the external world that the Trusts are controlling our empire, and Tata Sons board is more a dummy’.
A lack of clarity over what authority the Trusts have in relation to Tata Sons, and vice versa, was also
acknowledged in internal e-mails by Nitin Nohria, the dean of HBS, who has served on the Tata Sons board
as a Tata Trusts appointee since September 2013. Some governance experts have criticized his position there,
because the Trusts and some group firms made a $50m gift to Harvard Business School to fund a building that
was named in Mr Tata’s honour. Mr Nohria wrote in court documents that neither the donation, arranged shortly
before he became dean in 2010, nor the fact that he was appointed by the Trusts, should mean that he is not
acting in the interest of Tata Sons.
The main corporate-governance problem is that the interests of minority shareholders, whether they are
invested in Tata Sons or in the various operating companies, risk being trampled over if unaccountable trustees
are ruling the roost. But at the level of the businesses, improvised governance processes also slowed down
decision making to a crawl. Turf battles created confusion among executives as to who was in charge. Mr Tata,
in the legal filings, says it is untrue that the Trusts call the shots: he merely gave his advice when asked to, and
infrequently at that. Other trustees say they chipped in recommendations to Tata companies on important
matters in a personal capacity. On behalf of the Trusts, they merely sought better visibility into what money the
charities might receive as dividends from Tata Sons.
Yet at least one internal letter from Mr Tata suggests that he clearly expected the directors nominated by
the Trusts to convey the Trusts’ views to the Tata Sons board, rather than exercise their own judgement. In one
instance, in 2016, two directors nominated by the Trusts left a Tata Sons board meeting for nearly an hour to
confer with Mr Tata. Mr Mistry says this proves Mr Tata controlled the board; both directors have said that the
matter discussed was trivial. In India, ‘good corporate governance’ is often used as a euphemism for ‘not being
crooked’. By that standard, Tata still does well. Yet the manner in which Mr Mistry was defenestrated has raised
eyebrows in Mumbai’s business community. On Mr Tata’s recommendation, the Tata Sons board was suddenly
increased in size from six to nine directors just weeks before it voted to oust the chairman, which helped secure
Mr Mistry’s dismissal.
Tata insiders who reckon the crisis that befell them was purely driven by lacklustre profitability are misguided.
The poor governance that goes with the group’s Byzantine, multi-layered structure contributed to those low
profits, as well as to the bruising power struggle of recent months. Will Mr Chandrasekaran have the skill or
the mandate to simplify the group’s structure and rein in the influence of Tata Trusts? Although Mr Tata will
soon leave the board of Tata Sons, he shows little sign of retiring from his job as the chairman of the Trusts. But
Mr Chandrasekaran’s allies say in private that he has one huge advantage: having fired one successor, Mr Tata
knows he cannot sack another without further damaging his legacy.
Source: ‘Board stiff’, The Economist, 9 February 2017. Reproduced with permission.
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11.5.4 The Role of Non-Executive Directors
The collapse of Enron, a former energy trading giant, was felt far beyond the owners of the corporation. It wiped out
shareholders’ investments and employees’ retirement savings, and led to 21,000 people losing their employment.
Enron, once the seventh-largest company in the US, filed for bankruptcy in December 2001 with debts of £18 billion.
It had hidden these mounting debts through a series of complex financial dealings. Its collapse wiped out more than
$60 billion in market value. At the time Enron was praised by analysts as a new business model; it had been voted the
US’s most admired, innovative company.
The CEO’s use of market-to-market accounting allowed Enron to book potential future profits on the day a deal was
signed, irrespective of how much money was actually realized. For example, Enron lost $1 billion on a power plant in
India, but the company executives were paid multi-million dollar bonuses on the basis of profits which never materialized. It is clear that the demise of Enron owed much to inadequate checks by its external auditors Arthur Andersen
and weak controls within the company. Amanda Martin-Brock, a former Enron executive, has said that the fatal flaw at
Enron was ‘pride, then arrogance, intolerance and greed’.
In the UK, this lack of accountability led to the Higgs Report, whose remit was to look at the role and effectiveness of
non-executive directors. A decade earlier the Cadbury Committee had said that non-executive directors required independence of judgement if they were to perform their role effectively. The collapse of Enron cast doubt on the model
of effective non-executive directors challenging the decisions of executive board directors. Too often non-executive
directors were seen as merely rubber-stamping decisions taken by executive directors. The recommendations of the
Higgs Report included the following:
●
Non-executive directors should meet as a group at least once a year without executive directors being present.
●
The board should inform shareholders why they believe an individual should be appointed as a non-executive
director and how they meet the requirements of the role.
●
A full-time executive director should not hold more than one non-executive directorship or become chairman of
a major corporation.
11
These and other recommendations sought to tighten the role of non-executive directors in their accountability to
shareholders. Although the UK stopped short of legislation, the US was less reticent; it enacted sweeping legislation
in the form of the Sarbanes–Oxley Act.
The collapse of Enron is particularly disturbing given the wealth of experience of non-executive directors that sat on
the board. These included a British former cabinet minister and Energy Secretary, Lord Wakeham. The implosion of
Enron and WorldCom suggested to the US government that the self-regulatory regime in the US was not working
properly. It was quite apparent that it proved incapable of dealing with the largesse of corporate greed. The role of
non-executive directors at Enron is interesting. Their high salaries (each was paid a minimum of $350,000), long tenures (they had an average of seventeen years’ service), and lack of a nominating committee to ensure transparency
should have raised concerns earlier.59
The collapse of a major US investment bank, Lehman Brothers, was a result of the same arrogance and greed which
brought down Enron. We might ask where the lessons were learned from Enron and the checks and balances in the
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system to prevent such a collapse. A former Chancellor of the Exchequer, Alistair Darling, has queried why increasingly reckless lending was never checked by the boards of directors of the banks. He recognizes this is difficult when
profits are soaring and you have to challenge someone you know and like, but ultimately that is what boards are
there to do.60
11.5.5 The Sarbanes–Oxley Act
The Sarbanes–Oxley Act has been called a number of things—a knee-jerk reaction, a piece of poorly drafted legislation, perhaps even tick-boxing ad infinitum. A deeper question that Sarbanes–Oxley does not address is whether we
can (or indeed should) legislate for human greed. Sarbanes–Oxley was enacted in July 2002 by the US Congress. It
was proposed by Republican Congressman Michael G. Oxley and Democratic Senator Paul Sarbanes. It seeks to correct market imperfections by introducing financial disclosure rules and enhancements to statutory enforcements. The
main recommendations of Sarbanes–Oxley include the following:
●
chief executives now have to attest personally for the accuracy of company accounts—this is a concern for corporations wishing to list in New York and may explain the flight of funds to London;
●
a higher standard for board members who sit on the audit committee;
●
the prevention of loans to executives;
●
further criminal and civil penalties for securities violations.
A former US Treasury Secretary, Henry Paulson, stated that if the US capital markets are not to be disadvantaged,
its regulatory regime must be more responsive to changes in the marketplace. The concern of US corporations
is that they are now embroiled in far too much regulation. However, the financial crisis that was precipitated
by the collapse of major financial institutions may actually suggest that such institutions require more robust
regulation.
A concern with excessive executive pay is a perennial issue. However, the issue is not one of high salaries per se,
but the difference between fair and excessive compensation. In the UK, the Greenbury Report looked at investor
concerns over excessive directors’ pay.61 This followed the huge pay increases awarded to the heads of the recently
privatized UK public utilities. At the time, these chief executive officers were referred to as fat cats. Their role and
responsibilities remained the same post privatization as it had pre privatization; the only discernible difference was
their substantial increase in pay. Shareholders and institutional investors have become increasingly vocal about
what is seen as compensation for poor performance and the setting of easy bonus targets. There is evidence that
the views of shareholders are being taking into account. In 2016, almost sixty per cent of shareholders voted against
a £14 million pay package for the chief executive of BP in a year in which the company reported record losses, cut
thousands of jobs and froze its employees’ pay.62
The question is not always one of easy targets, but sometimes the question is simply: how much is enough? For example, in 2016, Sir Martin Sorrell received £48.1 million in total pay, bonuses and incentive scheme pay-outs. The remuneration, the last to be awarded under WPP’s controversial Leap scheme, means Sorrell has received around £210
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million in total remuneration since 2012. In 2015, he received £70.4 million, which was opposed by a third of shareholders at the annual general meeting (AGM).63 Sorrell has been subject to a number of shareholder voting revolts at
recent WPP’s AGMs. See Strategy in Focus 11.2.
For more discussion on the controversy surrounding executive remuneration, visit the online
resources see the Extension Material for this chapter.
www.oup.com/uk/henry3e/
STRATEGY IN FOCUS 11.2 Sir Martin Sorrell: Pay and
11
Performance at WPP
Sir Martin Sorrell, chief executive of WPP, the global marketing and group, received £48 million in remuneration
in 2016. That figure is thirty-one per cent lower than the £70 million he received in 2015, which represented one
of the biggest pay packages ever awarded to a FTSE 100 executive. The pay deal was opposed by one-third of
WPP shareholders at the annual general meeting (AGM). This is not the first time his pay has been rejected by
shareholders, all be it in a non-binding vote. In 2012, during what became known as the shareholder spring,
nearly sixty per cent of investors rejected his annual package. In 2014, thirty per cent of shareholders refused to
endorse Sorrell’s remuneration.
In conjunction with other corporations, WPP is seeking to introduce a less generous pay award for its
CEO, which is expected to pay out only £19 million a year. The proposal will be the subject of a binding
vote at WPP’s AGM. Hermes Investment Fund, an institutional shareholder in WPP, said in 2016 it was
‘highly uncomfortable’ with the ‘excessive’ scale of Sir Martin’s pay. As we saw above since 2012, Sorrell
has received around £210 million in total remuneration from the group’s long-term incentive scheme
know as Leap. In 2015, WPP’s long-term incentive scheme accounted for £62.8 million of the £70 million
he received.
Sorrell founded WPP in 1985, when he borrowed £250,000 to buy a stake in shopping basket maker Wire
& Plastic Products. Through a series of well-conceived acquisitions, it is now the world’s largest marketing
and advertising group. In fact, shareholders who have stayed with the group since its inception have seen a
substantial increase in their investment. Not surprisingly, Sorrell defends his pay awards. He argues that he has
put three decades of his life into turning WPP from a maker of wire baskets into a global marketing business
worth £22 billion. In addition, WPP represents a substantial proportion of his own wealth, which he has built up
over a considerable period of time. We might also note that compared to his US counterparts, his salary could
be seen as modest.
‘I’m not a Johnny-come-lately who picked a company up and turned it round [for a big payday]’, he said. ‘Over
those 31 years … I have taken a significant degree of risk. [WPP] is where my wealth is. It is a long effort over a
long period of time.’
Sources: Mark Sweney, ‘Sir Martin Sorrell’s pay package plunges from £70m to £48m’, The Guardian 28 April 2017; David Bond, ‘Sir Martin Sorrell to receive
£41.5m from WPP award scheme’, Financial Times, 9 March 2017; Mark Sweney and Jill Treanor, ‘Sir Martin Sorrell’s £42m payout takes earnings to £210m in
five years’, The Guardian, 9 March 2017.
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Research by the Economic Policy Institute found top chief executives earn more than 300 times what an average worker
makes.65 This differential has increased substantially over time. In the US, CEOs of major companies earned twenty times
more than an average worker in 1965. In 1978, this differential had grown to twenty-nine times. By 1989, it had doubled to
fifty-eight times more than an average worker, before accelerating in the 1990s to 376 times the average worker’s salary.
The financial crisis in 2008 resulted in a fall in CEO compensation, which meant that the CEO-to-worker compensation ratio
also fell. In 2014 the CEO-to-worker compensation ratio recovered to 303:1. See Case Example: Fat Cats and Starving Dogs.
The question the researchers seek to answer is whether the high compensation for chief executive officers is a result of
their talent or their ability to earn economic rent. Economic rent is the difference between the minimum price a seller
would except and the market price. Economic rent for CEOs is the difference between the minimum remuneration
they would except and what the market actually pays. It implies a payment above what a CEO would require to stay in
that position. The researchers conclude, ‘high CEO pay reflects rents, concessions CEOs can draw from the economy not
by virtue of their contribution to economic output but by virtue of their position’. As a result, CEO pay could be reduced
without the economy suffering any loss of output. A further implication of rising executive pay is that it reflects income
that otherwise would have accrued to others. In other words, the amount these chief executives earned meant money
was not available for salary increases for other workers.66
The concern over CEOs’ pay is not limited to shareholders. The former CEO and chairman of GE, Jeffrey Immelt, urges
business leaders to ensure their pay does not substantially outstrip that of their senior managers. Immelt believes that
if staff are to remain motivated and excessive remuneration is to be avoided, then CEOs’ pay should be a small multiple
of that of their twenty-five most senior managers. He argues that a multiple that represents up to five times what senior managers make is up for discussion. However, a multiple of twenty times he regards as madness. His own pay was
in the range of two to three times that of his top twenty managers.
11.7 Is Reform to Corporate Governance the Answer?
From this perspective corporate governance in the real world is not without faults, but corporate failures such as
Enron, Lehman Brothers, and Royal Bank of Scotland (RBS) are presented as statistical outliers rather than a systemic
problem. However, the refusal of the US and UK governments not to allow banking institutions to fail can be seen not
as a solution, but a symptom of a deeply dysfunctional financial system. Wall Street firms which disdained the need for
government regulation during the boom years were most insistent on being rescued by the government during the
financial collapse. Success was seen as an individual achievement, but failure a social problem.69
The second perspective argues that reforms need to be more radical. Whilst these reformers apportion some blame
to the auditors and regulators, they point out it was the governance mechanisms themselves which failed. This
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O’Sullivan proposes three different perspectives on corporate governance reform.67 The first is that the existing system
of corporate governance may need some revision, but only around the edges. Second, the system of corporate governance that assumes shareholder primacy needs to be changed, albeit leaving shareholders at the centre. Third, the
primacy of shareholders is itself open to question. The proponents of minor revisions to the existing system argue a
debate about the purpose of the corporation is not required. They see the proper role of the corporations as being the
maximization of shareholder value.68
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perspective does not, however, question shareholder primacy. A third perspective asks whose interest corporations
should be run in. It does not take it as self-evident that corporations should be run in shareholders’ interests. Andrew
Kakabadse and Nada Kakabadse argue that the pursuit of shareholders’ interests leads to ever-widening social inequalities.70 They suggest the governance debate would benefit from being pursued more at the societal/political level,
rather than the enterprise level. This view stems from their belief that the key issues surrounding governance are ones
of social inequality, not economic performance.
In the UK and US, discussions of corporate governance have invariably put shareholders above stakeholders, such as
employees. John Armour and his colleagues note that both the Sarbanes–Oxley Act in the US and the Higgs Report
in the UK completely ignore stakeholder claims in favour of further entrenching accountability to shareholders. They
undertook a study of corporate governance institutions in the UK and found that ‘certain core institutions—takeover
regulations, corporate governance codes and the law relating to directors’ fiduciary duties are indeed highly shareholder orientated’.71 On the basis of their analyses of UK institutions, they reject the claim made by some writers that
the fundamental issues of corporate ownership have been settled in favour of the shareholder value model.72
Those who adopt the stakeholder model of corporate governance recognize a central role for the corporation in wealth
creation, but see this in the wider context of meeting differing stakeholders’ needs. Whilst accepting the corporation
as a force for economic prosperity and social well-being, they argue that this wealth creation requires all stakeholders
to actively participate. Therefore, all stakeholders, including society, must be taken account of in the corporation’s
strategic decisions, including its distribution of the wealth which stakeholders have helped generate.
Those who adopt a model of corporate governance that enshrines the primacy of shareholders believe that corporations are the main engines for growth in industrialized societies, that a focus on stakeholders, many of which have
conflicting needs, leads to a misallocation of resources and ultimately less help for those members of society who may
need it most. The outcome of this might be to raise prices for consumers and/or lower the returns that shareholders
could have earned.73
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11.7.1 The Pursuit of Greed
The UK government was forced to use tax payers’ money to bail out failing British banks Royal Bank of Scotland and
Lloyds Banking Group to prevent their collapse. What went wrong with these and similar financial institutions? Kay,
points to the change in ownership as contributing to the financial crisis.74 In the past, we had partnerships and ownermanaged businesses. The ownership and control of the business lay in the hands of senior employees. The success and
loss from business activities was borne by these individuals, whose personal finances were at stake. In this structure,
partners would monitor each other’s activities, which effectively limited the risks the company incurred. As it was their
own money at stake, they were careful to engage in business activities they understood. The capital available to them
was limited to the company’s profits and their individual contribution to the partnership.
With the advent of limited liability companies and dispersed shareholding came the negligent management, speculation and risk-taking that Adam Smith warned against. Instead of long-term commitment to institutions, there
was short-term opportunism in pursuit of personal gain. For example, the chief executive of Lehman Brothers, Dick
Fuld, continues to be a very rich man after the collapse of the company he presided over. Many of the executives
of US financial institutions bailed out by the US government did not even lose their job. Fred Goodwin, who facilitated the collapse of RBS with his ill-conceived takeover of the Dutch bank ABN AMRO, was sacked and stripped of
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his knighthood. Goodwin’s pension was thought to be £400,000 per year, but it was actually double that amount.
This amount had been agreed when he was recruited by the then RBS top management. Despite government
ministers’ protests, and the failure of RBS board, Goodwin insisted on his contractual rights to his full pension.75
The co-chairman of Berkshire Hathaway, Charlie Munger, once gave a speech at Harvard Law School called ‘The
Psychology of Human Misjudgement’. In his talk he said if you wanted to predict how people would behave, you
only needed to look at their incentives.
In common with the US investment bank Lehman Brothers, RBS and other financial institutions exemplified management arrogance by engaging in activities that were peripheral to their core activities. It is argued that it is not bad
regulation of these institutions that caused the financial crisis, but ‘greedy and inept bank executives who failed to
control activities which they did not understand’.76 The Financial Services Authority’s report into the collapse of RBS
stated it overreached itself, engaging in risks the board of directors did not understand. It is clear that, given the risks it
was taking, RBS was massively undercapitalized in the event of failure.
The argument that banks cannot be allowed to remain ‘too big to fail’ has found support from the former Governor of
the Bank of England, Mervyn King. He argues that there is merit in dividing retail and investment banking operations
into separate, smaller businesses. That way, problems that arise in these individual elements do not jeopardize the
whole. King contended that if the Bank of England were to bail out the banking sector, this would introduce ‘moral
hazard’. Moral hazard occurs when people become indifferent to the consequences of their actions because they do
not have to meet the costs. If there is an expectation of government assistance for failing financial businesses, the
individuals who run these businesses will behave in ways that make the need for such assistance more likely.77
Others have argued that what is required is better regulation that is fully coordinated across international boundaries
to prevent such failures in the future. This coordination will protect consumers and the financial economy, preventing
the need for government assistance. However, this approach is seen by some to be little more than wishful thinking.
What is needed if we are to safeguard the economy and protect public finances is to ensure that the financial services
needed by individuals and businesses are regulated. At the same time, the government should refuse to underwrite
risk-taking. As long as banking groups know their activities will be underwritten by an implicit government guarantee,
for them it becomes ‘business as usual’.
Summary
Corporate governance as a discipline is in a state of flux. A main debate within corporate governance concerns whether
corporations should be run for the benefit of shareholders or stakeholders. Those who argue that corporations should
be run for shareholders cite the fact that shareholders are the owners of the corporation and it is their money that is at
stake. Those who argue the case for stakeholders are not convinced that stakeholders are simply a means to an end.
They argue that suppliers, customers, employees, and, yes, shareholders must all be able to participate in determining
the strategic direction of the corporation.
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It is difficult to escape the conclusion; if we have learned anything, it is that we haven’t learned anything. When the
next financial crisis happens Kay argues that a frustrated public may ultimately turn not only on politicians who have
been profligate with public funds, and bankers. They may also begin to question the legitimacy of the market economy
and capitalism.78
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Following the collapse of major organizations, a number of codes of conduct have been implemented in the UK; these
all seek to tighten accountability to shareholders. Sarbanes–Oxley has been implemented in the US following the collapse of the energy trading multinational corporation Enron. The collapse of major financial institutions such as Lehman Brothers spread unrest throughout global financial markets. One could be forgiven for expecting that this cycle
will simply repeat itself if nothing is learned. The thinking that major banks are too big to fail and must be propped up
by state intervention fails to factor in that this encourages unsustainable risk-taking. It will be interesting to watch corporate governance develop and monitor the direction that corporations take. It will also be interesting to see whether
regulation and codes of conduct can ever be effective against the pursuit of greed.
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CASE EXAMPLE Fat Cats and Starving Dogs
The debate over CEO pay is reminiscent of debates about corporate governance following a crisis; a great deal
of discussion occurs, but nothing really changes. There are at least two key strands in this debate. First, are performance measures for CEO pay simply too easy to achieve? Second, is the CEO pay excessive, particularly when
compared to the pay of an average worker?
The charity, the Equality Trust, called on the UK government to force firms to report the pay gap between the
highest-paid and average employee. The Equality Trust published a report in 2017 which showed that FTSE 100
chief executives make an average of £5.3 million per annum. Their analysis found that FTSE 100 CEOs are paid
165 times more than a nurse, 140 times more than a teacher, 132 times more than a police officer, and 312 times
more than a care worker.
‘The people who educate our children, look after our grandparents, and keep our families safe have seen their
pay frozen, while fat cat CEOs continue to gorge themselves on obscene and undeserved rewards’, said Equality Trust’s executive director. The average FTSE 100 chief executives earns 386 times more than a worker on the
national living wage earning £13,662 at £7.20 an hour. The Department for Business, Energy, and Industrial Strategy
commented: ‘We are committed to creating an economy that works for everyone, and that’s why we have consulted
on options to strengthen corporate governance.’
The concern over excessive executive pay is
not limited to charities. The UK government has
proposed the idea of providing shareholders
with the power to block pay deals deemed to be
too high. In the past, shareholder dissension at
the annual general meetings (AGM) on executive pay has been non-binding. For example,
Crest Nicholson, a FTSE 250 housebuilder vowed
to press ahead with bonuses for its bosses. This
was despite fifty-eight per cent of shareholders
opposing their pay policy in 2017. The company
BP chief executive, Bob Dudley. Source: © ID1974/Shutterstock.com
defended its decision to set more conservative
profit targets on the back of ‘the uncertain economic backdrop and the competitive environment in which the
company operates’. Its profit target was initially cut from a range of 18 pc and 22 pc to 16 pc and 20 pc. This has
since been reduced to a range of 5 pc to 8 pc. Reaching the target accounts for around half of the directors’ share
awards. Going forward, the voting on CEO pay is likely to be binding.
The oil giant, BP, cut the pay of its chief executive, Bob Dudley, by forty per cent in 2016 in an attempt
to avoid shareholder revolt over executive remuneration. BP has seen CEO remuneration soar while BP’s
profits and production plummeted in the years after the Deepwater Horizon disaster in the Gulf of Mexico
in 2010. Criticism of BP remuneration hit an all-time high in 2016 when around sixty per cent of votes cast
at the AGM went against the pay award. This was one of the largest dissents on pay by shareholders in a
large UK company. BP investors felt aggrieved as the company had awarded the CEO a 20 per cent pay
increase for 2015, even though BP reported a record annual loss that year. BP is not an isolated case; the
total pay of the boss of FTSE 100 company, Pearson, rose 20 pc, despite the education giant reporting a
record £2.6 billion loss for 2016.
The deputy chairman of ShareSoc, which speaks on behalf of thousands of retail investors in the UK, argues
that an AGM vote is too late in the day to alter pay policies. ‘The best way to solve the problem is to change the
remuneration committee and its members—to have outsiders on the committee or the board’, he says. However, companies continue to argue that they have to pay chief executives more to compete with their peers—
particularly in the US, where salaries are higher.
Some of the world’s biggest institutional investors are also voicing concern. The former chairman of Cadbury,
Sir Adrian Cadbury, once said that the institutional investors should let ‘exit’ give way to ‘voice’. In other words,
instead of selling their shares institutional investors should voice their concerns about the way companies are
managed. The US fund manager, BlackRock, points out that pay needs to be closely aligned to long-term performance. ‘We consider misalignment of pay with performance as an indication of insufficient board oversight,
which calls into question the quality of the board’, it said. In a letter to the heads of more than 300 UK companies, BlackRock stated it would only approve salary rises for top executives if companies also increase workers’
wages by a similar amount. Given the historic, conservative nature of institutional investors, this is seen as a
significant intervention. BlackRock has a shareholder in every FTSE 100 company with $5.1 trillion (£4.2 trillion)
of investments.
Norway’s oil fund, The Norges Bank Investment
Management, is one of the most influential shareholders in the world. It has a reputation as a responsible investor as a result of selling its investments in
coal and tobacco products. Historically, it has been
reluctant to share its views on executive remuneration. The Norges Bank Investment Management is so
large that it holds stakes in most major companies. It
supported the controversial pay deal for BP’s CEO, Bob
Dudley, although this was voted against by a majority
of shareholders.
For chief executive Yngve Slyngstad, the levels of pay—
not just structures—are now becoming a matter for international investor concern. In an interview with the Financial
Times he stated, ‘We have so far looked at this in a way that
has focused on pay structures rather than pay levels. We
The Manhattan headquarters of BlackRock, Inc, an American
think, due to the way the issue of executive remuneration investment management corporation. Source: © Isabelle OHara/
has developed, that we will have to look at what an appro- Shutterstock.com
priate level of executiv